THE  LIBRARY 

OF 

THE  UNIVERSITY 
OF  CALIFORNIA 

HENRY  RAND  HATFIELD 
MEMORIAL  COLLECTION 

PRESENTED  BY 

FRIENDS  IN  THE  ACCOUNTING 
PROFESSION 


HENRY 

2695  LEjTONT^AVENUE 

BERKELEY     CALIFORNW 


INVESTED    CAPITAL 
ACCOUNTING 

BASED  ON  THE  INTERNAL  REVENUE  ACT  OF  1918 


By 


JAMES  W.  BEERS,  B.  C.  S. 

•H 

Special  Lecturer  on  Invested  Capital  Accounting,  Chief  of  Training 
Section,  Staff  Division,  Income  Tax  Unit,  Bureau  of 

Internal  Revenue 

Member     National    Association    of    Cost    Accountants 
Author    of    "Stock    of    No    Par    Value — Its 

Economic  and  Accounting  Aspects" 
Co-Author,  "Accounting  Theory  and  Prob- 
lems With  Annotated  Solutions" 


WASHINGTON,  D.  C. 

ACCOUNTANTS'  PUBLISHING  Co. 
1922 


Copyright,  1922 

by 
JAMES  W.  BEERS 


NOTE:  The  purpose  of  copyrighting  this  work  is  not  to  exclude  the  use  of  its 
contents  in  the  work  of  the  Unit,  for  to  do  so  would  nullify  the  mission  of  the  book. 
The  object  in  procuring  a  copyright  is  to  prevent  unscrupulous  persons  from  making 
unfair  use  of  another's  work  (as  has  been  done  by  some  with  Training  Section 
material)  and  all  such  are  hereby  warned  that  use  of  its  contents  in  whole  or  in 
part  in  violation  of  copyright  laws  will  result  in  the  institution  of  legal  proceedings. 


iriitrattott 


To 

Hon.  DAVID  H.  BLAIR,  Commissioner  of  Internal  Revenue; 

E.    H.    BATSON,    Deputy    Commissioner    of    Internal 
Revenue  and  Head  of  Income  Tax  Unit; 

E.   W.    CHATTERTON,  Assistant   Deputy   Commissioner 
and   Production   Manager; 

W.  W.  HUBERT,  Assistant  Production  Manager; 

B.  E.  HUNSINGER,  Head,  Staff  Division,  Income  Tax  Unit, 

whose  steadfast  support  of  specialized  training  has  constantly  in- 
spired in  me  a  determination  ever  to  do  more  to  aid  fellow  employees 
to  arrive  at  that  stage  of  productive  efficiency  which  has  been  so 
much  desired  by  the  officials  of  the  Unit. 


BETWEEN  YOU  AND  ME 

In  days  of  long  ago  it  was  quite  customary  for  an 
author  to  print  in  the  forepart  of  his  book  the  names  of 
those  who  had  subscribed  for  the  work  before  issuance. 
That  is  a  custom  I  should  very  much  like  to  emulate, 
deeming  it  an  honor  to  publish  the  names  of  the  Income 
Tax  enthusiasts  who  have  made  the  publication  of  this 
book  possible,  but  lack  of  space  forbids. 

This  edition  consists  of  one  thousand  copies.  One 
thousand  persons  have  each  paid  for  a  copy  in  advance 
of  publication.  More  than  that,  not  one  of  the  thousand 
persons  was  asked  to  subscribe  for  the  book — every  sub- 
scription was  voluntarily  given.  If  any  one,  upon  receipt 
of  a  copy,  thinks  that  the  subscription  was  ill-advised,  he 
has  only  to  return  the  copy  to  me  and  his  money  will  be 
at  once  cheerfully  returned  to  him.  No  subscriptions  were 
received  by  the  author — all  was  done  independent  of  him. 
When  it  is  realized  that  very  few  technical  books  approach 
a  sale  of  a  thousand  copies,  even  after  publication,  it  will 
be  felt  that  this  is  a  remarkable  event  in  the  world  of 
books. 

The  advent  of  this  book  is  unusual  in  other  ways.  It 
is  received  by  the  subscribers  at  actual  cost  of  manufac- 
ture. The  authorship  rights  are  gladly  donated  for  this 
issue  with  no  thought  that  a  second  edition  will  at  any 
time  be  printed.  Not  a  penny  of  profit  accrues  to  any  one 
who  has  taken  an  interest  in  its  production,  and  stranger 
still,  no  subscriptions  were  accepted  from  persons  outside 
of  the  Income  Tax  Unit,  notwithstanding  the  fact  that  many 


persons  expressed  a  desire  to  subscribe.  No  additional 
copies  will  be  available — just  enough  are  being  printed  to 
fill  the  advance  subscriptions. 

This  book  is  in  effect  a  second  edition.  The  original 
edition  bore  the  title  of  "Invested  Capital  and  Excess 
Profits"  and  was  put  out  in  seven  mimeographed  pam- 
phlets by  the  Training  Section,  Income  Tax  Unit.  Thousands 
of  copies  were  issued  in  this  form  to  students  in  the  Unit. 
That  they  were  well  received  and  proved  beneficial  is  best 
evidenced  by  the  fact  that  this  re-written  and  enlarged 
edition  is  made  possible  by  the  voluntary  cooperation  of 
one  thousand  persons,  practically  all  of  whom  received  the 
mimeographed  edition  without  cost. 

The  writing  of  those  original  pamphlets  was  a  labor 
of  love — but  it  was  real  labor.  A  new  book  may  be  written 
on  nearly  any  subject  that  may  come  to  mind.  The  writer, 
while  his  work  may  be  original,  constantly  refers  to  pre- 
decessor publications  for  aid,  suggestions,  or  guidance  of 
some  sort.  But  in  the  production  of  those  pamphlets  there 
was  absolutely  nothing  that  could  be  referred  to,  not  a 
page  in  print,  not  a  mimeographed  sheet — nothing — abso- 
lutely nothing  preceded  them.  Many  questions  had  not 
yet  come  up  for  decision  in  the  Unit  and  it  required  a  good 
deal  of  courage  to  make  some  of  the  statements  that  were 
made  in  those  texts  relative  to  the  computation  of  in- 
vested capital.  It  is  gratifying  to  reflect  that  it  has  not 
been  found  necessary  to  change  a  single  essential  statement 
as  it  appeared  in  the  original  edition. 

It  is,  perhaps,  somewhat  unusual  for  an  author  to  give 
gratis  a  work,  the  writing  of  which  involved  many,  manv 
hours  of  his  own  time  in  his  home — time  he  could  have 
made  good  use  of  in  other  ways — when  he  had  flattering 
offers  from  publishers  to  place  it  on  the  market.  I  just 
said  "gratis,"  but  that  is  not  correct;  compensation  has 
been  received  for  it;  a  compensation  that  the  teacher,  in 
his  innermost  consciousness  values  more  than  money — the 
realization  that  he  has  produced  something  that  is  and  has 

vi 


been  the  means  of  helping  others  to  do  more  work — and 
better  work.  That  is  my  compensation,  and  it  is  satis- 
fying. 

I  feel  deeply  grateful  to  fellow  workers  who  have  aided 
me — who  with  me  groped  their  way  through  the  dark, 
looking  for  light  at  a  time  when  there  was  no  light,  and 
who  with  me  created  such  light  as  now  is. 

In  particular  do  I  wish  to  thank  Mr.  Edwin  D.  Evans, 
C.  P.  A.,  of  the  Consolidated  Review  Section,  Natural  Re- 
sources Division,  for  his  review  of  my  original  manuscript 
and  for  his  helpful  suggestions.  To  Mr.  John  M.  Hartman, 
Assistant  Chief  of  the  Training  Section,  I  extend  my  thanks 
for  the  privilege  of  including  in  this  book  Chapters  Three 
and  Four.  To  Mr.  Hugh  L.  Ducker,  B.  C.  S.,  Chief,  Tech- 
nical Subsection,  Training  Section,  and  Mr.  Ralph  D.  Toll, 
Assistant  Chief,  Technical  Subsection,  Training  Section,  I 
wish  to  express  my  appreciation  of  their  labors  in  reading 
the  entire  proof,  checking  up  all  of  the  computations,  and 
for  valuable  textual  suggestions. 

Just  a  word  in  my  own  behalf.  It  may  be  thought  by 
some  that  the  writing  of  the  "Invested  Capital  and  Excess 
Profits"  texts  naturally  devolved  upon  me  as  a  part  of 
my  duties  as  Chief  of  the  Training  Section.  To  correct 
any  such  misapprehension  it  is  only  necessary  to  state  that 
the  texts  were  written  before  I  became  Chief  of  Training 
Section — before  holding  any  official  position — even  before 
dreaming  that  I  would  ever  hold  such  a  position.  I  had 
entered  the  Unit  at  that  early  date  when  there  were  no 
helps  available  and  I  had  the  same  hard  struggle  to  master 
the  intricacies  of  invested  capital  that  others  had.  Being 
a  teacher,  I  wanted  to  help  others — that  was  the  primal 
cause  of  the  appearance  of  the  original  issues,  and  I  have 
been  actuated  only  by  the  same  desire  in  sacrificing  my 
own  time  to  put  forth  this  enlarged  and  more  presentable 
edition. 

JAMES  W.  BEERS. 
Washington,  D.  C. 
November  15,  1922. 

vii 


CONTENTS 

PAGE 

CHAPTER  ONE — FUNDAMENTALS 13 

Scope  of  These  Texts — What  is  a  Corporation? — Kinds  of  Cor- 
porations— Another  Classification — Corporation  Shares — Defini- 
tions— Determining  Net  Income  from  the  Balance  Sheet  (Illustra- 
tion)— Misleading  Profit  and  Loss  Statements — Limited  Partner- 
ships— Partnerships  Changing  to  a  Corporation — Reconciliation 
of  Surplus — Income  Tax  Computation — Fiscal  Year  (Illustra- 
tions.) 

CHAPTER  Two — GROSS  INCOME — DEDUCTIONS — NET  INCOME         -    37 
Gross  Income — Illustration  of  Net  Income — Interest. 

CHAPTER  THREE — INCOME — How  DETERMINED      -----      45 

Lessor  and  Lessee — Advantages — Income  from  Leased  Property — 
Payment  Direct  to  Corporation — Payment  to  Stockholders  and 
Bondholders  (Illustration) — Improvement  by  Lessee — Proportion 
of  Cost  to  Be  Included  as  Income  to  Lessor  (Illustration) — How 
to  Determine  Amount  to  Be  Included  as  Income  in  1920  (Illus- 
tration)— Effect  of  Present  Worth  on  Subsequent  Years — Effect 
of  Lease  Extending  Beyond  Life  of  Building — Income  of  Corpo- 
rations in  Liquidation — Receivership  or  Trustee. 

CHAPTER  FOUR — DEDUCTIONS  ALLOWED — BUSINESS   EXPENSES    -    58 

Deductions — When  Allowable — Period  Covered — Failure  to  Charge 
Off  the  Books — Embezzlement  and  Suit  for  Judgment — Business 
Expenses — Cost  of  Material  (Illustration) — Repairs — Professional 
Expense  (Illustration) — Compensation  for  Personal  Services — 

viii 


Salaries  and  Other  Compensation  Deductible  (Illustrations)  — 
Treatment  of  Excessive  Compensation — Compensation  Paid  Other 
Than  in  Cash — Bonuses  to  Employees  (Illustration) — Pensions 
( Illustrations)  — Rentals  ( Illustration) . 


CHAPTER  Five — CORPORATION  BONDS — GAIN  OR  Loss    -    -    -    -    73 

Illustrating  Article  544 — Gain  or  Loss  (Illustrations). 

CHAPTER  Six — PERSONAL  SERVICE  CORPORATIONS    ------    79 

What  is  a  Personal  Service  Corporation?  (Illustration) — The 
1917  Law — The  1918  Law — The  Difference  Illustrated — Change 
of  Ownership — Doing  Part  Personal  Service — Tax  Computation — 
Illustrating  Part  Personal  Service — Divergent  Views — A  Wrong 
Assumption — Amount  of  Capital — Further  Illustration — Income 
from  Royalties — A  Peculiar  Situation — A  Tentative  Answer  to 
the  Question. 

CHAPTER   SEVEN — CAPITAL  STOCK — TREASURY   STOCK    -    -    -    -    98 

Caution — Capital  Stock  (Various  Kinds) — Issued  at  a  Premium — 
No-Par  Stock  (Illustrated)— Treasury  Stock  (Illustrations)  — 
Returned  as  a  Gift>-The  So-Called  Double  Deduction— Valuation 
of  Property  Received  for  Stock — Treasury  Stock  Deductions  (Il- 
lustrated)— Value  Greater  Than  Par  Value  of  Stock  Issued 
Therefor— Partially-Paid-for  Stock— Bonus  Stock— Effect  of 
Stock  Dividend  (Illustrated) — More  About  Treasury  Stock — 
Equality  of  Treatment  (Illustrations) — Capital  Stock  Averaged 
— Fraction  of  a  Year — Borrowed  Capital — Gain  or  Loss  in  the 
Sale  of  Capital  Stock — Capitalizing  a  Bargain — The  Meat  in  the 
Cocoanut — Things  to  Remember. 

CHAPTER  EIGHT — SURPLUS — RESERVES — FUNDS 123 

Importance  of  Surplus — What  is  Surplus? — Surplus  and  No-Par 
Stock  (Illustrated) — Kinds  of  Surplus  (How  Created) — Divisions 
of  Surplus  (Reserves) — So-Called  Reserves  (Depreciation,  etc.) 
— Depreciation  Reserve  (Illustrated) — Other  So-Called  Reserves 
— One  Intelligible  Sign-Board — An  Exceptional  Treatment — An 

ix 


Exceptional  Reserve — Another  Guide-Post — Contingent  Reserves 
are  Invested  Capital — Specific  Reserves — Reserves  for  Insurance 
— Funds — Double  Use  of  the  Term  "Sinking  Fund" — Balance 
Sheet  Examples  of  the  Use  of  Terms — Illustrations  of  Invested 
Capital — Funded  Reserves — Suspended-Credit  Reserves — Secret 
or  Hidden  Reserves — Allowance  for  Doubtful  Accounts — An 
Anomaly — Things  to  Remember. 


CHAPTER  NINF — TANGIBLE  PROPERTY — INTANGIBLE  PROPERTY    -    151 

Definitions — Reason  for  Distinction — Quotations  on  Intangibles 
(The  Difference  Illustrated) — Tangible  Property  Paid  in  for 
Stock  or  Shares — Intangible  Property  Paid  in  for  Stock  or  Shares 
— Caution — An  Erroneous  Impression — An  Important  Exception 
— Depreciation  of  Intangibles — A  Hypothetic  Proposition  (Ex- 
tended Illustration) — Development  of  Patents  by  a  Corporation — 
Mixture  of  Tangibles  and  Intangibles — A  Different  Proposition — 
Attempting  the  Impossible? — Goodwill  and  No-Par  Value  Stock — 
Proration  of  Intangibles — Things  to  Remember. 


CHAPTER  TEN — ADMISSIBLES  AND  INADMISSIBLES      -  173 

What  is  an  Inadmissible  Asset? — What  are  the  Inadmissibles? — 
Confusion  Where  None  Should  Exist — Computation  Not  Difficult 
(Illustration)— Why  Divided  Into  These  Two  Classes— Differ- 
entiate Between  Bonds — The  Dividing  Line — The  Simplest  Com- 
putation (Illustration) — The  Usual  Procedure — Illustrative  Prob- 
lem— Formula — Prorating  Inadmissibles  (Illustration  and  Solu- 
tion)— Sold  at  a  Profit  and  Other  Income  Received  (Illustration 
and  Solution) — The  Averaged  Balance  Sheet — Rule  for  Averag- 
ing the  Balance  Sheet  (Problem  and  Solution) — Inadmissibles 
Sold  at  a  Loss — Inadmissibles  Exchanged  for  Admissibles — Stock 
Held  in  Foreign  Corporations  (Illustrations) — Organization  Ex- 
penses— Inadmissibles  Held  by  Trustee — "Proceeds" — Dealers  in 
Securities — Cardinal  Points — An  Intentional  Omission. 


CHAPTER  ELEVEN — DEPRECIATION — OBSOLESCENCE — APPRECIATION  201 

Definitions — Depreciation  ( Illustrated )  — Depletion  ( Illustrated ) 
— Obsolescence  (Illustrated) — Why  Depreciation? — Methods  of 
Computing  Depreciation — The  Straight-Line  Method — Unequal 


Percentage  Method — Declining  Value  Method — Percentage  of  De- 
preciation— Depreciation  Must  Be  Charged  Off — Depreciation  and 
Repairs — Discarded  Property  (Illustration) — Extraordinary  De- 
preciation— A  Profit  in  Place  of  a  Loss — Replacement  Value  and 
Depreciation — Amount  Recoverable  Through  Depreciation — Re- 
serve For  Depreciation — Intangible  Property  and  Depreciation 
— Patents — A  Peculiar  Condition — Realization  of  Appreciation 
(Illustration) — Depreciation  of  Models — Obsolescence  of  Build- 
ings— Appreciation  Must  Be  Placed  Where  It  Belongs  (Illustra- 
tions)— Birthday  of  Income  Tax  Law — Things  Worth  Remem- 
bering. 


CHAPTER  TWELVE— A.  R.  M.  106 228 

Remarks — The  Committee's  Memorandum — Author's  Comment — 
A.  R.  M.  106  Explained — Additional  Explanation — More  Ex- 
planation— Final  Comment. 


CHAPTER  THIRTEEN— RESUME— A  TYPICAL  CASE      -      -     -      -      239 
A  Revenue  Agent's  Report  and  Conclusions. 

CHAPTER  FOURTEEN— SOLUTION  TO  CHAPTER  THIRTEEN    -    -    -    249 

Comment — The  Return  Method  of  Computing  Invested  Capital — 
The  Author's  Method  of  Computing  Invested  Capital — Annotated 
Solution  and  Further  Comment. 

CHAPTER  FIFTEEN — A  GOOD  PROBLEM      -------      268 

An  Invested  Capital  Problem  and  An  Annotated  Solution. 

CHAPTER  SIXTEEN — EXCESS  PROFITS  QUIZZERS      -  284 


CHAPTER  ONE 

FUNDAMENTALS 


Foreword 


In  writing  this  book  no  effort  will  be  made  to  follow 
the  order  of  the  Articles  as  given  in  the  Regulations.  It 
is  thought  better  to  present  the  matter  by  topics,  so  far 
as  is  possible,  treating  each  topic,  or  group  of  topics  as 
a  unit.  Neither  shall  Regulations  be  quoted  to  any  extent; 
I  have  a  feeling  that  students  are  looking  for  something 
in  these  pages  that  they  do  not  find  in  Regulations — other- 
wise the  necessity  for  this  work  is  not  apparent.  If  the 
language  employed  seems  sometimes  vague  or  ambiguous, 
lay  the  blame  to  the  fact  that  the  author  is  blazing  a  new 
trail.  Were  he  to  write  a  text  on  accounting  or  on  chem- 
istry, or  on  any  one  of  dozens  of  other  subjects,  there  are 
hundreds  of  books  to  which  he  could  refer  and  from  which 
he  could  obtain  help.  In  the  present  case  there  is  nothing 
to  which  access  can  be  had  except  Regulations  and  the 
Bulletins,  and  you  already  have  them.  The  task  is  to 
create  a  new  book — no  one  in  the  Income  Tax  Unit  has 
yet  had  the  courage  or  the  hardihood  to  do  it — and  in 
the  creation  of  it  doubtless  you  will  find  evidences  of  short- 
comings, for  which  your  indulgence  is  craved. 

The  Scope  of  These  Texts 

No  dissertation  on  the  history  of  corporations  or  on 
the  reasons  for  incorporating  or  on  the  economic  effects 
of  income  tax  will  be  given ;  neither  is  the  text  matter,  nor 
the  illustrations  presented  to  be  considered  as  models  of 


14  INVESTED  CAPITAL  ACCOUNTING 

accounting  technique.  The  primary  object  is  to  teach  tax 
law  and  tax  law  accounting;  not  general  accounting.  The 
sole  aim  is  to  present  to  you  things  vital  in  your  work — 
in  other  words  we  shall  endeavor  to  get  right  down  to 
fundamentals  at  once. 

Originally  it  was  intended  to  present  only  a  revision 
of  the  series  known  as  "Excess  Profits  and  Invested  Cap- 
ital," but  many  persons  have  suggested  the  advisability 
of  including  in  this  book  the  author's  several  texts  on 
"Corporation  Tax  Law."  The  logical  place  for  these  is, 
of  course,  in  the  front  of  the  book.  Those  who  wish  to 
study  only  "Invested  Capital  Accounting"  may  do  so  by 
skipping  the  first  six  chapters  and  beginning  the  study  at 
Chapter  Seven. 

All  we  have  to  deal  with  here  is  the  effect  of  the 
1918  Income  Tax  Law  as  it  affects  corporations — what  cor- 
porations are  taxable,  and  why,  and  the  methods  of  arriving 
at  the  correct  amount  of  tax  in  any  given  case,  and  this 
brings  us  down  to  the  question — 

What  is  a  Corporation? 

Under  the  corporation  laws  of  the  various  states  a 
corporation  is  a  legal  entity;  that  is,  a  thing  complete 
within  itself — an  artificial  person  created  by  law.  It  can 
sue  and  be  sued;  acquire  and  sell  property;  can  make  con- 
tracts and  perform  such  other  activities  as  come  within 
the  provisions  of  its  charter. 

Blackstone  says : 


"A  corporation  is  an  artificial  person  created  for  preserv- 
ing in  perpetual  succession  certain  rights  which  being  con- 
ferred on  natural  persons  only  would  fail  in  the  process  of 
time." 


INVESTED  CAPITAL  ACCOUNTING  15 

Chief  Justice  Marshall  has  given  us  a  definition  from 
a  more  modern  viewpoint,  as  follows : 


"An  artificial  being,  invisible,  intangible,  and  existing  only 
in  contemplation  of  law.  Being  the  mere  creature  of  law, 
it  possesses  only  those  properties  which  the  charter  of  its 
creation  confers  upon  it,  either  expressly  or  as  incidental  to 
its  very*  existence.  These  are  such  as  are  supposed  best  cal- 
culated to  effect  the  object  for  which  it  was  created." 


The  assets  of  a  corporation  belong  to  the  corporation 
and  not  to  the  stockholders.  A  person  who  turns  property 
over  to  a  corporation  forfeits  all  direct  control  of  the  prop- 
erty. He  has  no  more  right  to  it  than  he  would  have,  had 
some  one  else  owned  the  property.  It  is  no  longer  his. 
If  a  stockholder  were  to  appropriate  corporation  property 
to  his  own  use,  he  would  as  certainly  be  guilty  of  larceny 
(in  the  eyes  of  law)  as  would  be  a  person  who  has  no  con- 
nection with,  or  interest  in  the  concern.  The  only  way 
he  can  exercise  any  control  over  such  property  or  over  any 
other  property  acquired  by  a  corporation  or  any  possession 
of  a  corporation  is  through  the  board  of  directors.  This 
board  acts  for  the  corporation  on  precisely  the  same  basis 
as  you  act  for  yourself  in  the  acquirement,  the  disposition 
of,  or  the  use  of  your  own  property. 


Kinds  of  Corporations 

Common  law  places  corporations  in  two  classes :  Public 
corporations  and  private  corporations. 

A  town  incorporates  and  becomes  a  borough  or  a  city ; 
that  is  a  public  corporation. 

Several  men  unite  in  some  business  enterprise  and 
file  application  with  the  secretary  of  some  state  for  a  char- 


16  INVESTED  CAPITAL  ACCOUNTING 

ter  to  permit  them  to  conduct  a  certain  line  or  certain 
lines  of  business  under  a  specific  name  at  some  definite 
place  or  places.  That  is  a  private  corporation. 

Private  corporations  are  subdivided  into  public  service 
corporations  and  business  corporations.  A  public  service 
corporation  is  one  dealing  in  some  commodity  necessary 
to  the  public,  as  a  water  company,  a  street  car  company, 
or  a  gas  company. 

But  in  income  tax  procedure,  while  in  the  main  these 
classifications  obtain,  corporations  are  classified  slightly 
different  in  some  respects.  We  have  eleemosynary  cor- 
porations, and  business  corporations,  personal  service  cor- 
porations, and  corporations  doing  a  part  personal  service 
business. 

(When  a  number  of  men  unite  in  some  enterprise, 
they  are  commonly  referred  to  as  a  "firm,"  but  when  the 
corporate  form  is  adopted,  it  is  often  spoken  of  as  the 
"company."  The  use  of  these  words  in  this  manner  is 
not  universal,  inasmuch  as  we  occasionally  hear  of  a  part- 
nership, as  well  as  a  corporation,  referred  to  as  a  company, 
as,  for  example,  John  Jones  &  Co.  might  be  a  partnership 
or  it  might  be  a  corporation.  The  word  "firm,"  however, 
should  never  be  used  in  connection  with  a  corporation.  Of 
course,  if  "Inc.,"  or  "Incorporated"  is  a  part  of  the  name, 
we  know  that  the  concern  is  not  a  partnership;  that  it 
is  a  corporation.  Frequently  the  name  does  include  "In- 
corporated" in  full  or  abbreviated,  but  inasmuch  as  its 
inclusion  is  not  always  obligatory,  the  custom  is  far  from 
universal.) 

An  eleemosynary  corporation  is  one  devoted  to  charity, 
and,  so  long  as  no  profit  inures  to  any  individual  connected 
with  it,  it  is  not  subject  to  tax. 

For   tax   purposes   we  may   expand  the  meaning   of 


INVESTED  CAPITAL  ACCOUNTING  17 

eleemosynary  to  include  a  number  of  other  corporations, 
such  as  those  devoted  to  educational  purposes,  or  to  relig- 
ious work,  or  to  scientific  matters,  or  to  societies  operated 
for  the  prevention  of  cruelty  to  children  or  animals. 

You  will  note  that  all  of  the  above  may  be  embraced 
in  a  common  class — all,  when  operated  without  profit  to 
any  stockholder  or  individual,  may  be  classed  as  corpor- 
ations organized  and  conducted  for  the  uplift  or  betterment 
of  social  conditions. 

To  this  class,  in  so  far  as  tax  is  concerned,  is  added 
a  number  of  corporations  conducted  for  various  purposes, 
that,  in  a  sense,  might  be  called  business  corporations,  but 
which  we  must  omit  from  that  class.  Such  corporate 
organizations  as  boards  of  trade,  business  leagues,  civic 
organizations,  chambers  of  commerce,  county  fairs,  ceme- 
tery companies,  etc.,  are  not  taxable,  provided,  that  they 
stand  the  test :  The  conduction  must  be  such  that  no  person 
received  or  can  receive  any  share  of  the  net  earnings  by 
virtue  of  his  connection  with  the  organization. 

Another  line  of  organizations  that  are  non-taxable 
(provided  they  qualify  under  the  above  test)  is  social  clubs, 
athletic  clubs,  literary  societies,  scientific  or  technical  socie- 
ties, labor  organizations,  and  other  societies  organized 
solely  for  pleasure,  recreation,  amusement  or  for  any  activ- 
ity not  conducted  for  profit. 

Still  another  class  is  mutual  insurance  companies, 
mutual  telephone  companies,  mutual  irrigation  companies; 
lodges  whether  or  not  they  are  beneficiary  in  character. 
There  are  both  kinds — the  Maccabees  are  obligated  to  pay 
benefits,  while  some  other  fraternal  organizations  are  not 
so  obligated. 

Then  there  is  the  other  "mutual  class" — building  and 
loan  associations,  mutual  savings  banks  and  cooperative 
banks  (provided  no  capital  stock  is  represented  by  shares), 


18  INVESTED  CAPITAL  ACCOUNTING 

associations  formed  by  fruit  growers,  farmers,  etc.,  con- 
ducted as  a  sales  agency  and  the  income  from  which  is 
distributed  on  the  basis  of  the  quantity  of  produce  turned 
over  to  the  association  for  disposal. 

It  should  be  observed  that  all  of  these  come  down  to 
a  single  proposition — the  matter  of  distributable  profits. 
The  question  is,  "Does,  or  could,  this  corporation  have 
net  income  any  part  of  which  would  inure  to  any  stock- 
holder, member,  or  individual?"  If  it  does,  or  could,  it 
is  taxable  the  same  as  are  other  taxable  corporations;  if 
not,  then  it  is  placed  in  the  non-taxable  class. 

It  is  suggested  that  you  study  Section  231  of  the  1918 
Revenue  Law,  and,  also,  Article  511  of  the  Regulations 
relating  to  "Proof  of  Exemption,"  and  Article  517  of  the 
Regulations  relating  to  eleemosynary  corporations.  A  close 
reading  of  Articles  beginning  with  512  and  ending  with 
522  is  advisable. 

Another  Classification 

Then  we  have  corporations  classified  as  Domestic  Cor- 
porations and  Foreign  Corporations.  A  Domestic  Corpor- 
ation is  one  operating  under  the  laws  of  any  one  of  the 
forty-eight  States  of  the  American  Union,  or  of  the  Dis- 
trict of  Columbia,  or  of  one  of  the  territories,  Alaska  and 
Hawaii.  All  others  are  Foreign  Corporations.  Right  here 
is  a  confusion  of  terms.  The  national,  or  income  tax  view 
and  use  of  the  terms  "domestic"  and  "foreign"  is  in  har- 
mony with  the  above  definition.  The  viewpoint  of  a  state 
official  is  this:  A  corporation  organized  under  the  laws  of 
his  state  is  a  domestic  corporation;  all  others  are  foreign 
corporations.  Thus,  a  corporation  organized  under  the  laws 
of  Pennsylvania  and  doing  business  in  New  York  State 
is  regarded  in  New  York  as  a  foreign  corporation.  You 
must  use  the  term  in  its  broad,  national  aspect ;  not  in  the 
restricted  state  sense. 


INVESTED  CAPITAL  ACCOUNTING  19 

Corporation  Shares — Definitions 

The  proprietary  interest  in  a  corporation  is  repre- 
sented by  shares,  or  stock  certificates,  commonly  called 
' 'stock"  and  broadly  subdivided  into  "Common  Stock"  and 
"Preferred  Stock."  These  divisions  are  often  further 
divided  into  other  classes  as  First  Preferred,  Second  Pre- 
ferred, etc.,  but  these  secondary  divisions  have  no  interest 
for  us  except  from  the  viewpoint  of  accountancy.  In  fact, 
it  is  but  seldom  that,  for  tax  purposes,  we  find  it  necessary 
to  make  separate  classifications  of  stock  even  as  to  Common 
and  Preferred. 

The  matter  of  stock  nomenclature  is  pretty  thoroughly 
covered  in  the  chapters  devoted  to  Excess  Profits  Account- 
ing, and  it  is  in  the  computation  of  Excess  Profits  tax 
that  we  find  most  use  for  such  knowledge.  However,  since 
this  chapter  is  one  of  the  steps  leading  up  to  Excess 
Profits  work,  it  seems  fitting  that  a  brief  description  be 
here  given  covering  certain  classes  of  stock. 

Common  stock  is  most  usual.  All  of  the  shares  of 
a  corporation  may  be  Common,  or  some  of  it  may  be  Pre- 
ferred. If  there'  be  Preferred  Stock  there  must  of  necessity 
be  Common  Stock. 

Broadly  speaking  the  difference  between  Common 
and  Preferred  is  that  in  case  of  dividends  the  Preferred 
comes  first.  Preferred  Stock  receives  a  specific  dividend 
percentage  rate.  In  the  event  that  the  amount  available 
for  dividends  is  insufficient  to  "go  around"  the  holders 
of  Preferred  get  the  dividend;  the  holders  of  Common  do 
not.  Preferred  Stock  may  be  cumulative  or  non-cumu- 
lative, but  these  features  are  thoroughly  covered  in  the 
Accounting  Course  of  the  Income  Tax  Unit.  Common 
Stock  usually  carries  voting  rights,  and  in  some  instances 
is  a  better  investment  than  Preferred  Stock. 


20  INVESTED  CAPITAL  ACCOUNTING 

Then  we  have  Issued  Stock  and  Unissued  Stock,  it 
would  seem  unnecessary  to  describe  these  terms,  but  un- 
fortunately, such  is  not  the  case.  Unissued  Stock  is  stock 
that  has  not  been  sold,  and  must  never  be  termed  Treasury 
Stock.  Issued  Stock  is  stock  that  is  or  was  sold  or  parted 
with  by  the  corporation.  If  some  (or  all)  of  this  stock 
(the  Issued  Stock)  was  bought  back  by  the  corporation, 
or  if  it  was  returned  to  the  corporation  as  a  gift,  it  then 
ceases  to  be  outstanding  stock  but  has  become  Treasury 
Stock.  Note  carefully,  exactly  what  is  Treasury  Stock.  You 
will  find  the  information  useful  later  on. 

Determining  Net  Income  from  the  Balance  Sheet 

A  corporation  reports  a  net  taxable  income  for  1919 
amounting  to  $105,000  and  submits  the  following  Balance 
Sheets: 


Assets:  Dec.  31,1918  Dec.  81,1919 

Cash    $30,000  $35,000 

Accounts  Receivable 20,000  15,000 

Sundry   Assets 300,000  350,000 


$350,000  $400,000 


Liabilities  and  Capital: 

Sundry  Liabilities $40,000  $21,000 

Allowance  for  bad  debts 6,000  10,000 

Reserve  for  Plant  Extension 15,000  30,000 

Surplus 89,000  139,000 

Capital   Stock 200,000  200,000 


$350,000  $400,000 


It  reports  that  a  dividend  of  $50,000  was  declared  and 
paid  December  10,  1919,  and  that  a  $5,000  donation  made 


INVESTED  CAPITAL  ACCOUNTING  21 

to  the  Salvation  Army  was  charged  to  Profit  and  Loss. 
(Had  this  item  been  a  charge  to  Surplus  it  would  not  affect 
our  computation  since  we  are  arriving  at  net  taxable  in- 
come from  the  Balance  Sheets,  not  from  the  Profit  and 
Loss  Statement.) 

Upon  investigation  we  find  no  other  unallowable  de- 
ductions except  $20,000  income  tax  paid  for  1918.  We 
find  that- 


Surplus  at  the  end  of  the  year  exceeds  surplus  at  the 

beginning  of  the  year  by $50,000 

Dividends  paid    50,000 


Apparent  total  increase  in  value $100,000 

Plus  unallowable  items   (donations) 5,000 


Taxable  income  as  reported $105,000 


Is  this  amount  ($105,000)  the  correct  taxable  income? 
No,  though  it  doubtless  would  so  appear  to  the  stockholders 
who  are  prone  to  look  upon  the  amount  received  in  divi- 
dends plus  the  increase  in  Surplus  as  typifying  the  net 
earnings. 

To  the  $105,000  must  be  added  the  1918  income  tax 
paid  in  1919  making  a  taxable  income  of  $125,000. 

Have  we  now  arrived  at  the  taxable  net  income?  We 
have  not.  In  income  tax  procedure  and  with  one  or  two 
exceptions  in  accepted  accounting  practice,  charges  to  Sur- 
plus items  which  are  not  deductible  are  only  surplus  under 
other  names  set  apart  for  a  specific  purpose. 

In  computing  net  income  under  the  1918  tax  law,  tax- 
payers are  not  permitted  to  deduct  any  amount  for  possible 
future  losses  arising  from  bad  debts.  Only  such  an  amount 
may  be  deducted  as  has  actually  been  determined  to  be 


22  INVESTED  CAPITAL  ACCOUNTING 

worthless  during  the  taxable  year  and  which  has  been 
charged  off. 

In  the  proposition  before  us,  we  find  that  at  the  begin- 
ning of  the  year  the  balance  sheet  carried  a  Bad  Debt 
Allowance  of  $6,000  and  at  the  end  of  the  year,  this  Allow- 
ance is  increased  to  $10,000  so  we  must  add  $4,000  more 
to  the  taxable  income.  It  matters  not  that  this  $4,000 
may  prove  worthless  during  the  coming  year  and  that  there 
is  every  reason  to  believe  that  it  will  so  prove.  This  is 
one  of  the  instances  in  which  income  tax  procedure  diverges 
from  accepted  accounting  practice,  for  the  public  account- 
ant probably  would  make  a  charge  to  Profit  and  Loss  of 
$4,000.  The  tax  accountant  must  not  do  so.  You  will 
readily  perceive,  of  course,  that  if  this  allowance  had  not 
been  increased  that  Surplus  would  have  been  $4,000  greater ; 
the  increase  being  brought  about  by  an  entry  something 
like  this: 


Profit  and  Loss $4,000 

Allowance  for  Bad  Debts $4,000 

(Appropriate  Explanation) 


Also  we  find  that  Reserve  for  Plant  Extension  has 
been  increased  by  $15,000,  which  amount  is  nothing  but 
allocated  surplus  and  must  be  added  to  the  taxable  income. 
If  this  amount  had  already  been  expended  for  necessary 
repairs,  the  reduction  in  net  income  would  be  reflected 
through  Profit  and  Loss,  but  this  particular  reserve  is  set 
up  for  future  use.  If  this  amount  had  been  expended  in 
the  past  (or  if  expended  in  the  future)  for  additions  and 
betterments,  this  reserve  would  disappear  and  Surplus 
would  be  increased  by  a  like  amount  brought  about  by 
entries  something  like  the  following: 


INVESTED  CAPITAL  ACCOUNTING  23 

Reserve  for  Plant  Extension $15,000 

Cash  (or  Accounts  Payable) $15,000 

(Explanation) 

Plant    $15,000 

Surplus    $15,000 

(Explanation) 

You  will  note  from  this  that  all  additions  to  the  reserves 
that  are  not  deductible  from  gross  income  in  arriving  at 
net  taxable  income  must  be  added  back  to  Surplus  to  get 
the  taxable  income  from  the  balance  sheets. 

You  will  also  note  that  taxable  net  income  is  usually 
greater  than  the  actual  book  income  although  it  might 
be  less  as  we  shall  see  later  on.  In  this  proposition  the 
actual  book  income  is  $119,000  while  the  taxable  income 
is  $144,000. 

Limited  Partnerships 

Some  limited  partnerships  are,  in  effect,  corporations, 
and  should  be  taxed  as  such.  Others,  termed  "limited 
partnerships"  by  the  various  statutes  of  the  several  states 
authorizing  such  combinations  of  individuals  engaged  in 
business,  are  nothing  more  than  ordinary  or  common  law 
partnerships.  To  determine  whether  any  of  the  so-called 
limited  partnerships  are  to  be  given  a  status  of  corporations 
for  income  and  excess  profits  tax  purposes,  or  are  to  be 
taxed  through  the  individuals  composing  them  (or,  under 
the  1917  Revenue  Act,  as  partnerships),  knowledge  must 
be  had  of  the  nature  of  the  statute  under  which  they  are 
created  and  the  scope  of  the  powers  and  limitations  granted 
them. 

In  some  states,  notably  Pennsylvania,  a  form  of  limited 
partnership  is  found,  which,  to  all  intents  and  purposes, 
is  a  corporate  form  of  business  organization.  The  liability 
of  the  partners  is  restricted  to  certain  definite  limitations, 


24  INVESTED  CAPITAL  ACCOUNTING 

shares  are  issued  and  may  be  transferred  without  affecting 
the  business.  The  death  of  a  partner  does  not  dissolve  the 
business.  They  may  sue  and  be  sued,  and,  generally,  exer- 
cise most  of  the  prerogatives  of  an  ordinary  corporation. 

However,  simply  because  a  state  law  provides  for  the 
formation  of  a  partnership  form  of  organization  like,  or 
similar  to,  the  form  in  vogue  in  Pennsylvania,  does  not 
imply  that  all  partnerships  in  that  state  are  limited.  In 
Pennsylvania,  for  instance,  are  to  be  found  many  partner- 
ships that  do  not  have  any  semblance  to  the  corporate 
form  of  organization. 

These  will  be  found  to  be  only  common  law  partner- 
ships. In  some  states  provision  is  made  for  a  limited  form 
of  partnership  in  which  only  a  certain  class  or  division  of 
the  persons  composing  the  organization  enjoy  the  liability 
limitation,  while  the  general  partners  are  not  immune  from 
liability  to  the  creditors  of  the  concern.  Such  partnerships 
are  to  be  classed  as  ordinary  partnerships. 

The  following  are  the  chief  factors  that  determine  that 
a  partnership  is  not  to  be  taxed  as  a  corporation : 

1.  If  death  of  a  member  dissolves  the  partnership. 

2.  If  shares  are  not  issued,  or  if  an  interest  in  the 
partnership  be  not  subject  to  transfer  at  the  dis- 
cretion of  a  partner. 

3.  If  liability  to  creditors  be  not  limited. 

4.  If  title  to  real  estate  cannot  be  taken  or  given  in 
the  partnership  name. 

5.  If  the  partnership  cannot  sue  or  be  sued. 

Generally  speaking,  any  provisions  in  a  partnership 
organization  which  would  be  the  opposite  in  effect  from 
the  above  conditions  would  be  good  grounds  for  classing 


INVESTED  CAPITAL  ACCOUNTING  25 

the  partnership  as  coming  within  the  corporate  form  and 
for  taxing  it  as  a  corporation. 

Partnerships  Changing  to  Corporation 

Study  Article  933.  You  will  note  from  this  article  that 
a  capitalistic  corporation  organized  prior  to  July  1,  1919, 
that  is  a  successor  to  a  business  previously  conducted  as 
a  partnership,  or  by  an  individual,  may  elect  to  be  taxed 
as  a  corporation  from  January  1,  1918,  provided  its  net 
income  for  the  taxable  year  1918  is  equal  to  or  exceeds 
20  per  cent  of  its  invested  capital.  When  you  arrive  at 
the  Invested  Capital  Accounting  section  of  this  book  you 
will  be  fully  advised  as  to  what  constitutes  invested  capital 
and  how  the  amount  is  determined. 

Misleading-  Profit  and  Loss  Statements 

That  a  Profit  and  Loss  statement  may  reveal  a  certain 
amount  of  net  income  is  not  necessarily  indicative  that  the 
amount  revealed  is  the  net  taxable  income.  The  cardinal 
reasons  for  this  are : 

1.  Items  may  have  been  charged  to  Profit  and  Loss 
through  Expense  Account  that  should  have  been 
capitalized.  Thus,  the  cost  of  a  machine  might  be 
charged  to  Expense,  inadvertently  or  otherwise, 
and  the  net  profit  indicated  by  the  Profit  and  Loss 
Statement  would  be  less  than  it  should  be  to  the 
amount  of  the  cost  of  the  machine.  We  occasion- 
ally see  organization  expenses  charged  to  Expense ; 
such  expenses  should  be  capitalized. 

It  is  sometimes  found  that  the  total  discount  on 
bonds  has  been  charged  to  Profit  and  Loss  at  the 
time  of  issue. 

Let  us  say  that  ten-year  bonds,  face  value 
$10,000,  are  sold  for  $9,000.  Each  year  during  the 


26  INVESTED  CAPITAL  ACCOUNTING 

life  of  the  bonds  $100  should  be  charged  to  Profit 
and  Loss.  To  do  otherwise  is  to  charge  the  current 
year  with  an  expense  incurred  for  future  years, 
and,  in  the  case  of  some  corporations,  this  might 
operate  to  show  a  loss  for  the  first  year,  when,  in 
fact,  there  was  an  actual  profit.  You  understand, 
of  course,  that  discount  on  bonds  is,  in  effect,  ad- 
ditional interest. 

Analytic  examination  of  Expense  Accounts  is 
one  of  the  most  fruitful  sources  of  additional  net 
income.  The  auditor  who  accepts  a  taxpayer's 
Profit  and  Loss  Statement  without  question,  es- 
pecially if  expense  amounts  seem  out  of  propor- 
tion to  the  volume  of  business  done,  is  not  per- 
forming his  full  duty. 

The  cost  of  installing  new  machinery  is  a  capital  ex- 
penditure ;  not  an  allowable  deduction. 

Items  such  as  the  following  should  not  be  charged  to 
Profit  and  Loss,  directly  or  indirectly,  as  all  such  expenses 
(so-called)  represent  capital  outlay,  and,  as  more  fully 
explained  in  the  chapters  on  Invested  Capital  Accounting 
constitute  a  part  of  the  concern's  invested  capital: 

(a)  Cost  of  installing  new  machinery,  and  engineer's 
drawings,  etc.,  used  in  connection  therewith. 

(b)  Architectural  drawings  and  supervision  of  new 
construction. 

(c)  Surveys,  maps,  plats,  etc.,  necessary  in  connection 
with  the  acquirement  of  realty. 

In  a  broad  sense,  any  expenditure  necessary  in  con- 
nection with  the  acquirement  of  an  asset  is  a  part  of  the 
cost  of  the  asset  and  should  be  capitalized  as  such,  while 
any  expenditure  incidental  to  the  upkeep  of  the  asset  should 
be  a  charge  to  Profit  and  Loss  through  an  appropriate  Ex- 


INVESTED  CAPITAL  ACCOUNTING  27 

pense  Account.  This  matter  is  more  fully  covered  in  a 
subsequent  chapter;  the  accounting  technique  required  is 
explained  in  the  Accounting  Course  of  the  Income  Tax 
Unit. 

To  illustrate  the  above:  The  California  Wine  Co.,  pur- 
chased in  France,  a  big  wine  press ;  cost  in  France  on  board 
boat,  $10,000.  Ocean  freight,  $1,000;  import  duty,  $3,000; 
brokerage,  $100;  freight  from  New  York  to  California, 
$1,000;  cartage  from  freight  house  to  plant,  $500;  en- 
gineer's plans  for  and  supervision  of  installation,  $200; 
labor  of  installing,  $300.  All  of  these  items  are  capital 
expenditures;  none  should  be  charged  to  Expense.  Total 
amount  to  be  capitalized  is  $16,100. 

2.  Profit   and   Loss   may   have   been   credited   with 
earned  or  partly  earned  profits  that  are  not  taxable 
or  that  should  be  taxed  over  a  period  of  years. 
For  instance,  a  concern  issues  $10,000  face  value 
bonds  and  sells  them  for  $11,000.    The  bookkeeper 
or  the  management  may  look  upon  the  extra  $1,000 
as  profit  and  credit  it  to  Profit  and  Loss.    This  is 
incorrect  practice.    The  $1,000  should  be  amortized 
over  the  life  of  the  bonds.    Assuming  the  life  of 
the  above  bonds  to  be  ten  years,  $100  only  should 
have  been  credited  to  Profit  and  Loss.     (The  mat- 
ter of  bonds  is  covered  in  a  subsequent  chapter.) 
Or,  it  may  have  sold  Treasury  Stock  at  a  price 
greater  than  the  cost  price  to  the  corporation  and 
the  difference  may  have  been  credited  to  Profit  and 
Loss.     This   would  be  non-taxable  income.     See 
Article  542. 

3.  Items  may  have  been   capitalized  which   should 
have  been  charged  to  Profit  and  Loss  through  an 
Expense  Account.     This  would  tend  to  show  a 
greater  net  income  than  actually  was  earned.    To 
illustrate:    Tools  having  a  life  of  one  year  or  less 


28  INVESTED  CAPITAL  ACCOUNTING 

should  be  charged  to  Expense — not  to  Plant,  or 
to  Equipment;  Patterns  or  molds  made  for  a 
special  job,  or  whose  apparent  usefulness  is  but 
temporary,  should  be  charged  to  Expense,  while 
other  patterns  or  molds  should  be  capitalized. 
Advertising  is  another  item,  much  of  which  falls 
within  this  class.  It  may  be  true,  as  contended 
by  some,  that  all  advertising  tends  to  build  up 
goodwill;  that  point  we  do  not  care  to  discuss. 
As  a  matter  of  fact,  the  great  bulk  of  advertising 
is  a  current  expense,  pure  and  simple,  and  is  a 
proper  charge  to  Selling  Expense. 

4.  Items  may  have  been  charged  to  Profit  and  Loss 
in  an  incorrect  amount.  Thus,  if  excessive  de- 
preciation is  charged,  the  net  income  is  under- 
stated; if  charged  at  too  low  a  rate,  the  net  in- 
come is  overstated. 


5.  Items  may  have  been  charged  to  Profit  and  Loss, 
which  from  long  established  procedure,  is  consid- 
ered good  practice,  but  which,  in  income  tax  pro- 
cedure, are  not  allowable  deductions  from  gross 
income.  To  cite  an  example :  A  concern  may  hold 
a  lot  of  commercial  paper  (promissory  notes)  and 
feels  that  some  of  it  will  prove  uncollectible, 
hence  it  charges  a  percentage  of  the  total  to  Profit 
and  Loss.  This  is  good,  conservative  practice,  and 
is  followed  by  good  accountants,  but  in  determin- 
ing net  taxable  income  it  is  an  unallowable  deduc- 
tion. Another  item  belonging  to  this  class  of  de- 
ductions is  income,  excess  profits  and  war  profits 
taxes,  which  are  not  deductible  items,  although 
they  do  reduce  the  taxpayer's  net  income  available 
for  distribution  or  for  investment. 


INVESTED  CAPITAL  ACCOUNTING 
Reconciliation  of  Surplus 


29 


The  following  "balance"  or  equation  must  always  be 
present : 


Total  Surplus  at  the  be- 
ginning of  the  year 
PLUS  the  year's  earnings 
PLUS  other  credits  to 
Surplus 


must 
exactly 
balance 
with 


Total  Surplus  at  the  end 

of  the  year 

PLUS  Dividends  paid  dur- 
ing the  year 
PLUS  other  charges  to 
Surplus 


Or,  to  put  it  in  another  way — 


Total  Surplus  at  the  be- 
ginning of  the  year 
PLUS  the  year's 

earnings 

PLUS  other  credits  to 
Surplus 


minus 


Dividends  paid 

Total  Sur- 

during the 

should 

plus  shown 

year,  and  othei 

equal 

by  the  books 

charges  to 

the 

at  the  end 

Surplus 

of  the  year 

Note:  By  "Total  Surplus"  is  meant  all  items  that  are 
real  surplus,  whether  they  be  called  "Undivided 
Profits,"  or  under  any  one  of  the  numerous  names 
given  Reserves  that  are  actual  reserves,  as,  to 
cite :  Reserve  for  Contingencies,  or  Improvements, 
or  other  similar  items,  appropriately  designated 
"Allocated  Surplus."  A  "true  reserve,"  or  Allocated 
Surplus  is  real  surplus  set  up  under  a  different  name 
by  making  a  Journal  entry  charging  Surplus  and 
crediting  the  Reserve,  as: 


Surplus    $5,000 

Reserve  for  New  Machinery $5,000 

(Appropriate  Explanation) 


30 


INVESTED  CAPITAL  ACCOUNTING 


Let  us    see  what    this  sometimes    proves, 
abridged  Balance  Sheets  disclose  the  following: 


Certain 


Assets: 


Dec.  31,  1918     Dec.  31,  1919 


Cash $5,000 

Plant    100,000 

Inventory 70,000 

Receivables    35,000 


$210,000 


$50,000 

120,000 

73,000 

32,000 

$275,000 


Liabilities  and  Capital:  Dec.  31,  1918 

Capital   Stock $75,000 

Surplus    65,000 

Undivided    Profits 15,000 

Allocated  Surplus   (True  Reserves) 35,000 

Notes   Payable 20,000 


$210,000 


Dec.  31,  1919 
$75,000 
65,000 
55,000 
50,000 
30,000 


$275,000 


This  concern  reports  a  net  taxable  income  of  $103,000 ; 
dividends  paid  $40,000;  income  tax  $15,000;  donations 
$5,000;  credit  to  surplus  of  $2,000  profit  on  the  sale  of 
Treasury  Stock. 


Will  the  statement  reconcile?    Let  us  see — 

Surplus  and  Undivided  Profits  at  the  beginning  of 

the  year 

Allocated  Surplus  (True  Reserves) 

Earnings  as  reported 

Other  credits  to  Surplus 


Less :  Dividends  paid $40,000 

Allocated  Surplus  (True  Reserves) 50,000 

Income  Tax 15,000 

Donations 5,000 


$80,000 

35,000 

103,000 

2,000 

$220,000 


110,000 


$110,000 


INVESTED  CAPITAL  ACCOUNTING  31 

Surplus  does  not  reconcile  in  this  proposition. 

On  the  basis  of  the  taxpayer's  statement  the  books 
should  show  a  Surplus  of  $110,000  at  the  end  of  the  year, 
but  we  find  that  the  Balance  Sheet  reveals  $120,000.  (Sur- 
plus and  Undivided  Profits.)  It  is  certain  that  the  tax- 
payer's statement  is  incorrect  or  there  is  an  error  in  the 
Balance  Sheets.  In  such  cases  it  is  the  auditor's  duty  to 
locate  the  error.  If  that  can  not  be  done  by  the  aid  of 
the  information  at  hand,  the  taxpayer  should  be  requested 
to  explain.  In  the  above  proposition  apparently  taxable 
income  is  understated  by  $10,000. 

You  will  see  from  the  above  that  the  attempted  recon- 
ciliation proves  the  existence  of  an  error.  It  cannot  be 
too  strongly  impressed  upon  you  the  fact  that  reconciliation 
of  Surplus  and  Undivided  Profits  is  the  signboard  that 
points  the  way  to  correct  determination  of  net  income. 
If  you  are  weak  in  this  phase  of  tax  procedure,  you  are 
earnestly  advised  to  make  a  special  study  of  the  subject 
at  once. 

But  note  this  particularly:  Surplus  may  reconcile  to 
a  cent;  the  Balance  Sheets  may  be  absolutely  correct,  but 
if  donations  and  income  and  excess  profits  taxes  have  been 
charged  to  Expense  or  direct  to  Profit  and  Loss  or  to 
Surplus  you  must  add  such  amounts  to  the  net  income 
that  has  been  revealed  by  a  comparison  of  the  Balance 
Sheets  as  at  the  beginning  and  as  at  the  end  of  the  taxable 
period. 

Income  Tax  Computation 

As  will  be  seen  from  Article  502,  before  computing  the 
income  tax,  certain  credits  are  allowed  which  reduce  the 
taxable  income.  The  chief  credits  are: 

(a)     An  exemption  of  $2,000,  which,  in  the  case  of 


32  INVESTED  CAPITAL  ACCOUNTING 

a  domestic  corporation,  is  free  from  tax.     Foreign  cor- 
porations do  not  enjoy  this  exemption.    See  Article  591. 

(b)  The  amount  of  excess  profits  tax  and  war  profits 
tax  of  the  taxable  year,  is  a  credit.     Since  excess  profits 
tax  is  completely  covered  in  a  subsequent  chapter  no  com- 
putation in  that  respect  will  be  required  at  present.    The 
several  propositions  will  state  the  amount  of  excess  profits 
and  war  profits  taxes. 

(c)  Interest  received  upon  obligations  of  the  United 
States  and  from  bonds  issued  by  the  War  Finance  Cor- 
poration if  any  such  interest  has  been  included  in  gross 
income,  should  be  deducted. 

You  must  distinguish  clearly  between  "income  tax" 
and  "excess  profits  tax."  The  former  is  the  tax  on  income ; 
the  latter  is  not  a  tax  on  income  but  is  a  tax  on  abnormal 
or  "excess"  profits  with  relation  to  the  amount  of  capital 
invested  in  the  business. 

The  proper  procedure  is:  First,  after  arriving  at  true 
net  income,  deduct  $2,000  (if  a  domestic  corporation).  The 
balance,  if  there  be  no  profits  taxes,  is  taxable  at  the  rate 
of  12%  in  1918  and  10%  in  subsequent  years. 

Let  us  assume  that  the  Keenedge  Cutlery  Company 
had  a  net  income  in  1918  of  $8,000.  We  will  further  assume 
that  its  invested  capital  is  such  as  to  eliminate  all  profits 
taxes.  For  1918  its  income  tax  would  be  12%  of  ($8,000 — 
$2,000),  or  $720.  For  1919  its  tax  would  be  (basing  on 
$8,000  net  income)  10%  of  ($8,000— $2,000),  or  $600. 

Now  let  us  assume  that  this  corporation  had  an  income 
of  $20,000  for  1918  and  $25,000  for  1919.  Also  that  the 
profits  tax  for  1918  is  $8,000  and  for  1919  it  is  $10,000. 
(The  method  of  determining  profits  taxes  will  be  presented 
later.)  Again  we  will  assume  that  it  receives  $300  interest 


INVESTED  CAPITAL  ACCOUNTING  33 

from  obligations  of  the  United  States  in  each  of  the  years 
named  and  which  is  not  subject  to  tax. 

The  tax  will  be  computed  as  follows:  (The  numbers 
beginning  with  each  line  correspond  with  the  numbers  in 
Schedule  IV  of  the  return  Form  1120.) 


12.  Net  income  for  taxable  year  (1918) $20,000 

13.  Less  interest  on  obligations  of  the  U.  S. . .  $300 

14.  Less  profits  tax 8,000 

15.  Less  exemption 2,000       10,300 


16.  Amount  subject  to  income  tax 9,700 


17.  Tax  of  12%   on  Item  16 1,161 

18.  Profits   tax 8,000 

20.  Total    tax $9,164 


For  1919  the  computation  would  differ  only  in  amounts 
and  rate — 


Profits  Tax   (Schedule  D) $10,000 

5.  Net  income  for  taxable  year $25,000 

6.  Less  interest  on  obligations  of  the 

U.    S $300 

7.  Less  profits  tax 10,000 

9.  Less    exemption 2,000       12,300 


10.  Amount  subject  to  income  tax $12,700 

11.  Tax  of  10%  on  item  10 1,270 

12.  Total  tax $11,270 


Fiscal  Year 

The  foregoing  computations  are  on  the  calendar  year 
basis.     Now  let  us  assume  that  this  company  keeps  its 


34  INVESTED  CAPITAL  ACCOUNTING 

books  on  a  fiscal  year  basis  that  begins  September  1,  1918, 
and  ends  August  31,  1919,  of  the  next  year,  and  that  for 
the  fiscal  year  the  net  income  was  $40,000.  The  total  war 
and  excess  profits  taxes  computed  under  the  1918  law, 
we  assume  to  be  $36,000,  of  which  the  amount  applicable 
to  that  portion  of  the  year  included  in  1918  is  four-twelfths 
or  $12,000.  The  total  profits  tax  computed  under  the  1919 
law  we  assume  to  be  $30,000,  of  which  the  amount  appli- 
cable to  that  portion  of  the  year  included  in  1919  is  eight- 
twelfths  or  $20,000. 

Of  course,  it  is  clear  to  you  that  in  such  event  the 
proportionate  part  of  the  tax  applicable  to  the  calendar 
year  1918  must  be  added  to  the  proportionate  part  of  the 
tax  applicable  to  the  calendar  year  1919  in  order  to  obtain 
the  total  war  and  excess  profits  taxes  for  the  fiscal  year. 

The  proposition  is:  How  should  we  determine  the 
correct  amount  of  tax  liability  of  a  corporation  that  files 
its  return  on  a  fiscal  year  basis?  The  procedure  is  as 
follows.- 

Ascertain  the  correct  profits  taxes  by  making  two  com- 
plete tax  computations,  one  on  the  basis  of  the  1918  tax 
law  and  one  on  the  1919  tax  law  and  take  that  portion  of 
the  tax  for  each  year  as  the  number  of  months  in  each 
calendar  year  is  of  the  entire  period.  These  two  amounts 
added  together  will  give  the  total  profits  taxes  for  the 
fiscal  year. 

The  income  tax  is  obtained  by  taking  the  net  income 
for  the  taxable  year,  less  the  specific  exemptions,  computed 
on  the  basis  of  the  rates  for  each  year  and  taking  that 
proportion  of  the  total  for  1918  which  the  number  of 
months  is  of  the  number  of  months  in  the  period  and  that 
proportion  of  the  total  for  1919  which  the  number  of 
months  is  of  the  number  of  months  in  the  period.  These 
two  amounts  added  together  give  the  total  income  tax  for 
the  period. 


INVESTED  CAPITAL  ACCOUNTING  35 

The  Proposition  Illustrated 

Summary  of  War  and  Excess  Profits  Taxes 

Total  war  and  excess  profits  taxes  applicable  to  the  calendar 

year  1918 $12,000 

Total  excess  profits  tax  applicable  to  the  calendar  year  1919 . .  20,000 

Total  war  and  excess  profits  taxes $32,000 


Computation  of  Income  Tax 

16.  Net  income  for  the  fiscal  year $40,000 

18.  Less:  War  and  excess  profits  taxes $32,000 

19.  Exemption    2,000       34,000 

20.  Balance  subject  to  income  tax $6,000 


21.  Tax  of  12%   (1918  law) 720 

22.  Tax  of  10%   (1919  law) 600 

23.  Inasmuch  as  four  months  of  the  fiscal  year  come 

in  the  calendar  year  1918,  the  portion  of  the 
tax  applicable  to  1918  is  four-twelfths  of 
$720  or 240 

24.  Inasmuch  as  eight  months  of  the  fiscal  year  come 

in  the  calendar  year  1919,  the  portion  of  the 
tax  applicable  to  1919  is  eight-twelfths  of 
$600  or 400 


25.  Total  income  tax $640 


Summary 

26.  War  and  excess  profits  tax $32,000 

27.  Income   tax 640 

30.  Total  tax $32,640 


A  fiscal  year  beginning  in  1919  and  ending  in  1920 
would  be  computed  but  once — just  the  same  as  it  would 
be  computed  were  it  a  calendar  year,  for  the  reason  that 
the  rates  for  1919  and  1920  are  the  same.  This  same 


36  INVESTED  CAPITAL  ACCOUNTING 

procedure  will  hold  good  just  so  long  in  the  future  as  the 
1918  income  and  excess  profits  tax  rates  remain,  unchanged. 

Part  of  a  Year 

In  the  event  that  a  corporation  files  a  return  for  part 
of  a  year  as  when  a  change  is  made  from  a  fiscal  year 
basis  to  a  calendar  year  basis,  the  $2,000  exemption  should 
be  prorated. 

Thus  if  the  Keenedge  Cutlery  Company  had  been  filing 
returns  on  the  fiscal  year  basis  as  at  August  31,  and  it 
had  been  decided  to  change  to  the  calendar  year  basis,  a 
return  would  be  filed  for  the  four  months  period  ended 
December  31,  1919.  In  its  return  for  the  yearly  period 
ended  August  31,  1919,  it  took  advantage  of  the  $2,000 
exemption,  hence  2/3  of  the  $2,000  is  reflected  in  that 
return.  For  the  four-months  period,  exemption  must  be 
reduced  to  the  number  12ths  of  $2,000  that  is  equal  to 
the  numbers  of  months  embraced  in  the  part-year  period; 
in  this  case  4/12  exemption  being  $666.67. 


CHAPTER  TWO 
GROSS  INCOME— DEDUCTIONS—NET  INCOME 

In  accounting  parlance,  income  (disregarding  for  the 
time  being  the  terms  "gross  income"  and  "net  income") 
is  usually  divided  into  three  classes — operating  income, 
non-operating  income,  and  financial  income. 

Operating  income  is  income  derived  through  the  reg- 
ular course  of  business.  Thus,  a  manufacturer  of  furniture 
sells  a  dozen  chairs.  The  receipts  from  the  chairs  is  oper- 
ating income. 

Non-operating  income  may  be  derived  from  the  sale 
of  a  capital  asset  at  a  price  above  its  worth  or  above  its 
cost.  Thus,  someone  may  wish  to  conduct  a  restaurant 
on  a  corner  lot  owned  by  the  manufacturer  which  adjoins 
the  factory,  and,  owing  to  its  proximity  to  many  workers, 
the  party  is  willing  to  pay  a  big  price  for  it.  The  taxpayer 
may  sell  some  securities  which  have  been  held  pending 
a  rise  in  the  market.  The  profit  derived  from  these  and 
similar  transactions  would  be  non-operating  income. 

Financial  income  may  be  derived  in  a  number  of  ways. 
The  manufacturer  referred  to  may  lend  some  money  at 
interest.  The  interest  accrued  or  received  would  be  finan- 
cial income. 

By  the  way,  a  great  many  persons,  more  or 
less  educated,  would  have  used  the  word  "loan" 
in  the  above  sentence  in  place  of  "lend."  Such 
usage  is  not  good.  "Loan"  is  employed  only 
as  a  noun  in  the  best  English. 

Apropos  of  correct  English,  here  is  a  list  of 


38  INVESTED  CAPITAL  ACCOUNTING 

words  almost  universally  mispronounced.  In 
each  of  the  following  words  give  the  "a"  in 
the  accented  syllable  the  long  sound  of  the 
vowel,  as  heard  in  "same": 


Da-ta  Gra-tis  Pro-ra-ta 

Da-turn  Ap-pa-ra-tus  Er-ra-ta 

Sta-tus  Ig-no-ra-mus  Er-ra-tum 

Note  the  following : 

Finance ;  short  i  as  in  fin ;  accent  on  the  second  syllable. 

Financial;  short  i  as  in  fin;  accent  on  the  second 
syllable. 

Financier ;  short  i  as  in  fin ;  accent  on  the  last  syllable ; 
pronounced  fi-nan-seer. 

Amortize ;  accent  on  the  second  syllable. 

Amortization;  primary  accent  on  the  fourth  syllable; 
secondary  accent  on  the  second  syllable. 

Now,  while  the  various  classes  of  income  should  always 
be  segregated  in  books  of  account,  not  permitting  non- 
operating  profits,  or  any  profits  not  directly  the  result  of 
regular  business  operations  to  appear  as  a  credit  to  Profit 
and  Loss  we  in  the  audit  are  not  particularly  interested  in 
the  matter  of  what  account  is  credited  with  the  income, 
but  we  are  intensely  interested  in  the  question — "Is  this 
income  taxable  ?"  So  we  classify  all  income,  first  as  "Gross 
Income,"  and  "Net  Income,"  and  subdivide  the  latter  into 
"taxable"  income  and  "non-taxable"  income. 

Gross  Income 

In  a  sense  "gross  income"  is  synonymous  with  "gross 
profits,"  as  revealed  by  a  trading  statement,  and  from  that 
amount  certain  deductions,  termed  roughly  "operating  ex- 


INVESTED  CAPITAL  ACCOUNTING  39 

penses,"  are  taken,  which  gives  us  "net  profit,"  or  "net 
income." 

To  make  it  clearer,  a  merchant  sells  a  stove  for  $50. 
The  $50  is  not  income  or  "gross  income"  for  at  least  a 
part  of  that  $50  represents  only  transformation  of  capital. 
Assuming  that  the  stove  cost  the  merchant  $50,  the  trans- 
action to  that  extent  only  indicates  that  the  merchant 
exchanged  one  stove  (a  part  of  his  capital)  for  $50,  in 
Cash,  Accounts  Receivable,  or  Notes  Receivable,  and  what- 
ever it  was  that  he  received  for  the  stove  is  still  capital  but 
changed  in  nature.  The  $50  is  not  income  of  any  kind. 

But  let  us  assume  that  this  merchant  sold  during  the 
year  a  lot  of  stoves  (or  other  goods)  and  that  he  sold,  or 
aimed  to  sell,  them  at  a  profit.  He  had  goods  on  hand  at 
the  beginning  of  the  year,  and  since  he  was  not  retiring 
from  business,  he  had  goods  on  hand  at  the  end  of  the 
year.  If  he  had  marked  each  item  at  its  exact  cost,  and 
each  time  he  made  a  sale  he  credited  a  Profit  Account 
with  the  difference  between  the  cost  of  the  goods  and  the 
selling  price,  he  would  at  the  end  of  the  year  be  able  to 
ascertain  his  gross  profit  by  adding  up  the  profit  items 
and  deducting  from  that  amount  the  losses,  if  any  goods 
had  been  sold  below  cost.  But  such  a  scheme  is  not  prac- 
tical. Many  items  are  purchased  by  the  merchant  by  the 
dozen,  or  in  other  quantitative  lots,  and  the  unit  cost  of 
each  item  is  expressed  in  odd  cents,  or  a  fraction  of  a 
cent.  Besides,  the  labor  of  keeping  such  records  would 
be  monumental,  and  the  time  required  to  make  such  records 
at  the  time  of  the  sale  would  be  so  great  that  additional 
clerks  would  be  required,  and  every  clerk  would  of  neces- 
sity have  to  know  just  how  much  the  merchant  made  on 
a  sale.  That  would  be  very  undesirable,  and  the  chances 
of  error  would  be  greatly  multiplied. 

The  customary  and  best  way  to  arrive  at  the  desired 
result  is  by  the  inventory  method.  At  January  1,  this  mer- 


40  INVESTED  CAPITAL  ACCOUNTING 

chant  had,  let  us  say,  $35,000  worth  of  goods  on  hand. 
That  is  his  opening  inventory.  The  ledger  shows  that 
during  the  year  Purchases  were  charged  wfth  $65,000,  Sales 
Account  is  credited  with  $93,000  during  the  year,  and  at 
December  31  an  inventory  is  taken,  showing  $38,000  worth 
of  goods  on  hand.  That  is  his  closing  inventory. 

By  setting  up  a  simple  Trading  Statement  we  readily 
arrive  at  Gross  Profit — 


Opening  Inventory $35,000         Sales $93,000 

Purchases 65,000         Closing  Inventory   38,000 

Gross  Profit 

(To  profit  and  loss) . .  31,000 


$131,000  $131,000 


Of  course,  in  practice,  other  accounts  would  enter  into 
the  above,  as  Freight,  Return  Sales,  Return  Purchases, 
etc.  Our  aim  is  not  to  teach  accounting  in  this  series,  but 
to  teach  tax  law,  bringing  in  accounting  features  only  to 
the  extent  necessary  to  illustrate  and  explain  the  law  and 
its  application. 

The  above  $31,000  represents  the  Gross  Profit,  but 
what  we  are  after  is  the  Net  Profit.  In  selling  these  goods 
certain  expenses  were  incurred,  and  all  of  these  expenses 
must  be  deducted  before  we  find  Net  Profit,  the  amount 
that  would  ordinarily  be  carried  to  Surplus.  Hence  we  have 
recourse  to  the  Profit  and  Loss  Statement.  Gross  Profit 
is  a  credit  balance  in  the  Trading  Account,  and  when  carried 
to  Profit  and  Loss,  thus — 


Trading    $31,000 

Profit   and    Loss $31,000 

(Suitable  explanation) 


INVESTED  CAPITAL  ACCOUNTING  41 

The  Trading  Account  is  closed  out,  and  we  have  a  credit 
of  $31,000  to  the-— 

Profit  and  Loss  Statement 

Wages  and  Salaries $6,000         Gross  Profit  from 

Rent 2,400  Trading   $31,000 

Insurance 1,000 

Bad  Debts  charged  off  . .      500 
Interest  paid   (or 

accrued) 100 

General  Expense 2,000 

Net  Profit, 

(carried  down) 19,000 


$31,000  $31,000 


Net  profit  carried  to 

Surplus $19,000 


There  are  allowed  as  deductions  all  the  necessary  ex- 
penses of  doing  business,  which  may  embrace  many  items 
not  given  in  our  Profit  and  Loss  Statement.  Doubtless  you 
have  been  through  the  course  on  Individual  Tax  Law,  and 
have  made  a  study  of  deductions.  Almost  the  same  deduc- 
tions are  allowed  corporations  as  are  permitted  individuals. 
A  notable  exception  is  Donations,  which  the  individual 
may  deduct  (to  a  limited  extent),  and  the  corporation  may 
not  deduct  to  any  extent.  One  deduction  is  allowed  cor- 
porations that  an  individual  may  not  take — dividends  re- 
ceived from  other  taxable  corporations.  Special  deductions 
are  allowed  insurance  companies,  but  that  matter  will  not 
be  taken  up  here. 

In  the  problem  just  presented  we  find  the  net  income 
to  be  $19,000.  As  stated  in  another  chapter,  an  exemption 
of  $2,000  is  allowed,  leaving  in  this  instance  a  net  taxable 
income  of  $17,000.  We  did  not  charge  Profit  and  Loss  with 
depreciation  inasmuch  as  inventories  may  not  be  depre- 


42  INVESTED  CAPITAL  ACCOUNTING 

ciated,  and  nothing  enters  into  the  problem  but  goods.  If, 
however,  this  taxpayer  had  depreciable  property,  such  as 
a  building,  delivery  trucks,  furniture  and  fixtures,  Profit 
and  Loss  should  be  charged  with  the  usual  amount  of  de- 
preciation for  the  year.  The  question  of  depreciation  will 
not  be  treated  to  any  great  extent  in  this  chapter,  inasmuch 
as  it  is  completely  covered  in  the  chapter  devoted  to  "De- 
preciation— Obsolescence — Appreciation." 

The  statement  that  corporations  may  not  deduct  dona- 
tions is  a  little  too  inclusive.  Article  562 :  "Donations  made 
by  a  corporation  for  purposes  connected  with  the  operation 
of  its  business,  when  limited  to  charitable  institutions, 
hospitals,  or  educational  institutions,  conducted  for  the 
benefit  of  its  employees,  or  their  dependents,  are  a  proper 
deduction  as  ordinary  and  necessary  expenses."  Also,  you 
will  note  by  reading  this  Article  that  certain  other  dona- 
tions are  deductible,  but  note  particularly,  "sums  of  money 
expended  for  lobbying  purposes,  the  promotion  or  defeat 
of  legislation,  the  exploitation  of  propaganda,  including 
advertising  other  than  Trade  Advertising,  and  contribu- 
tions for  campaign  expenses  are  not  deductible  from  gross 
income."  The  example  of  the  stove  dealer  cited  above  may 
also  illustrate  the  procedure  that  would  be  followed  in 
arriving  at  the  gross  income  of  any  dealer,  and  with  account- 
ing modifications  which  have  no  bearing  on  tax  law,  may 
be  applied  to  manufacturers  and  other  forms  of  business. 

One  thing  to  note  particularly  in  the  matter  of  in- 
ventories is  that  the  inventory  at  the  beginning  of  the 
year  must  coincide  exactly  with  the  inventory  shown  on 
the  books  at  the  close  of  the  previous  year.  If  this  is  not 
the  case  you  will  probably  have  to  correspond  with  the  tax- 
payer, and  ask  him  to  explain  (in  case  he  has  not  done  so 
in  his  return)  the  discrepancy. 


INVESTED  CAPITAL  ACCOUNTING  43 


Interest 


Under  the  1917  Income  Tax  Laws  the  amount  of  in- 
terest that  was  deductible  is  limited.  Under  the  Act  of 
1918  the  amount  deductible  is  not  limited,  but  an  exception 
is  made  of  interest  paid  for  one  specific  purpose. 

Interest  on  indebtedness  incurred  or  continued  to  pur- 
chase or  carry  an  asset  (usually  a  security)  the  interest 
(note  the  law  says:  "Interest,"  not  "income")  from  which 
is  wholly  exempt  from  taxation,  is  not  deductible. 

This  last  item  has  caused  a  great  deal  of  confusion 
in  the  minds  of  students  and  auditors.  An  inadmissible 
asset  is  an  asset,  the  income  from  which  (be  it  interest 
or  dividends)  is  exempt  from  tax.  In  this  class  of  assets 
may  be  named  municipal  bonds  and  industrial  stocks,  for 
in  the  case  of  municipal  bonds  the  interest  is  exempt  from 
taxation,  and  in  the  case  of  stocks,  the  dividends  received 
therefrom  are  exempt  from  tax.  Now,  if  a  corporation 
borrows  money  to  purchase  a  municipal  or  state  bond,  it 
cannot  deduct  the  interest  paid  (or  accrued)  from  gross 
income  in  arriving  at  taxable  net  income,  because  the  in- 
terest returned  by  the  bonds  is  exempt  from  taxation,  but 
if  it  borrows  money  to  purchase  industrial  stocks,  the  in- 
terest paid  (or  payable)  on  this  money  is  deductible  for 
the  reason  that  the  law  refers  only  to  the  matter  of  non- 
taxable  interest,  and  is  silent  on  non-taxable  dividends. 
Whether  this  was  intentional  on  the  part  of  Congress,  or 
was  an  oversight,  is  immaterial  to  us.  Right  or  wrong 
the  canons  of  the  law  must  be  carried  out.  It  is  not  in- 
cumbent upon  us  to  decide  what  Congress  intended  to  do; 
we  must  follow  along  with  what  it  did  do. 

Some  have  formed  the  erroneous  opinion  that  the  de- 
ductibility  of  interest  paid  to  purchase  or  carry  stocks 
automatically  restores  the  stock  to  admissible  assets.  Such 
is  not  the  case.  The  subject  of  asset  classification  is  ex- 


44  INVESTED  CAPITAL  ACCOUNTING 

tensively  treated  in  the  chapter  devoted  to  "Admissibles 
and  Inadmissibles." 

The  expressions  "incurred  or  continued"  and  "to  pur- 
chase or  carry"  have  seemed  ambiguous  to  some.  Interest 
"incurred"  is  interest  on  money  borrowed  during  the  tax- 
able period  to  "purchase"  non-taxable  bonds,  while  interest 
"continued"  is  interest  on  money  borrowed  during  a  pre- 
vious period,  and  which  is  still  being  used  to  "carry" 
the  bonds. 


CHAPTER  THREE* 

INCOME  FROM  LEASED  PROPERTIES  AND  CORPOR- 
ATIONS IN  LIQUIDATION  (ARTICLES 
546  AND  547) 

Income — How  Determined 

Income  ordinarily  includes  gains,  profits  and  income 
derived  from  every  source  whatsoever  and,  broadly  speak- 
ing, means  all  wealth  flowing  in  to  the  taxpayer  other  than 
a  mere  return  of  capital.  However,  gains  derived  from 
the  sale  or  other  disposition  of  capital  assets  are  income. 
Furthermore,  there  are  other  items  which  are  income- 
determining  factors  besides  cash,  among  which  are  inven- 
tories, accounts  receivable,  property  exhaustion  and  accounts 
payable  for  expenses  incurred.  Gross  income  for  income 
tax  purposes  embraces  all  of  the  above  forms  of  income 
unless  wholly  exempt  from  tax  by  statute.  When  income 
is  derived  from  leased  property  and  corporations  in  liqui- 
dation, its  taxability  is  determined  in  accordance  with  the 
following  principles : 

Lessor  and  Lessee 

Buildings  and  land  owned  by  corporations  are  fre- 
quently leased  to  other  corporations  by  which  the  lessee 
corporation  secures  control  of  competing  concerns  through 
rental  of  a  certain  plant  or  property  over  a  period  of  years. 
This  may  also  occur  where  a  corporation  wishes  further 

"This  chapter  is  from  the  pen  of  Mr.  John  M.  Hartman,  Assistant 
Chief,  Training  Section,  Income  Tax  Unit. 


46  INVESTED  CAPITAL  ACCOUNTING 

to  avoid  the  expense  of  building  operations  or  the  necessary 
delay  in  beginning  business  in  connection  with  erecting 
buildings  and  plant.  On  the  other  hand  the  lessor  cor- 
poration may  desire  to  lease  its  plant  in  order  to  be  relieved 
of  the  operation  of  its  property,  and  at  the  same  time 
receive  a  satisfactory  return  on  its  capital  in  the  way  of 
rentals.  Leases  actually  run  from  1  to  50  years  and  some- 
times as  high  as  99  or  999  years.  Leases  of  this  nature, 
however,  are  equivalent,  to  permanent  ownership  and  the 
lessee  corporation  may  improve  the  property  as  desired. 
As  a  rule  the  lessee  corporation  obligates  itself  to  pay  tax, 
insurance,  and  the  upkeep  expense  of  the  leased  property. 
The  corporation  owning  the  property  is  designated  as  the 
"lessor;"  the  corporation  securing  the  lease  is  called  the 
"lessee." 

Advantages 

Moreover,  it  may  be  advantageous  for  a  corporation 
to  lease  its  property  over  a  fixed  period  by  which  a  certain 
return  on  its  investment  is  guaranteed  rather  than  conduct 
its  business  with  the  possible  chance  of  loss  where  com- 
petition is  very  keen.  Leased  property  continues  in  pos- 
session of  the  lessor  and  must  be  returned  at  the  expiration 
of  the  lease.  The  advantages  to  the  lessee  may  be  cited 
as  long  occupancy,  which  enables  the  lessee  to  plan  for 
future  business  and  the  establishment  of  pre-determined 
rental,  advantages  which  might  be  necessary  in  the  case 
of  continuous  interruptions  where  changes  of  location 
should  occur.  A  permanent  location  is  much  desired  in 
establishing  goodwill  and  the  building  up  of  trade  where 
locations  are  desirable,  and  a  long-term  lease  meets  this 
requirement  at  least  in  part,  as  it  insures  the  lessee  cor- 
poration against  open  competition. 

Income  from  Leased  Property 

When  a  corporation  leases  its  property  to  another 


INVESTED  CAPITAL  ACCOUNTING  47 

corporation  under  a  lease  contract  the  proportionate 
amount  of  annual  rental  for  each  year  is  taxable  income 
to  the  lessor  corporation  during  the  life  of  the  lease.  Let 
us  assume  that: 

Payment  Direct  to  Corporation 

Corporation  A,  the  lessor  corporation,  leases  its  plant 
to  the  B  Corporation  for  $10,000  for  a  period  of  ten  years, 
to  be  paid  annually.  The  A  Corporation  reports  income 
at  the  rate  of  $1,000  per  annum  for  ten  years.  However, 
in  case  of  a  short-term  lease,  where  the  entire  amount  of 
the  lease  for  the  period  held  is  paid  the  first  year  of  the 
lease,  the  entire  amount  received  for  the  lease  would  be 
taxable  income  to  the  lessor  for  the  year  received,  pro- 
vided its  books  are  kept  on  a  cash  receipts  basis.  Where 
a  corporation  has  leased  its  property  and  the  lessee  in 
lieu  of  other  rental  agrees  to  pay  an  amount  equivalent  to 
a  certain  rate  of  dividend  on  the  lessor's  capital  stock  or 
the  interest  on  the  lessor's  outstanding  indebtedness,  to- 
gether with  tax,  insurance  or  other  fixed  charges,  such 
payments  shall  be  considered  rental  payments  and  shall 
be  returned  by  the  lessor  corporation  as  income. 

Payment  to  Stockholders  and  Bondholders 

When  payments  on  a  lease  are  made  directly  to  the 
stockholders  and/or  bondholders  of  the  lessor,  they  are  still 
considered  as  income  to  the  lessor  corporation.  Simply 
because  a  corporation  has  parted  with  the  management 
and  control  of  its  property  or  has  ceased  to  engage  in  the 
business  for  which  it  was  originally  organized  will  not 
relieve  it  from  tax  liability.  Payments  of  this  nature  made 
by  the  lessee  corporation  directly  to  the  bondholders  or 
stockholders  of  the  lessor  corporation  are  considered  as 
rental  as  to  both  the  lessee  and  lessor  corporation.  They 
are  considered  as  rentals  paid  in  one  case  and  rentals 
received  in  the  other.  Any  amounts  received  by  the  bond- 


48  INVESTED  CAPITAL  ACCOUNTING 

holders  and  stockholders  in  this  case  are  considered  as 
interest  and  dividend  payments  received  from  the  lessor, 
and  as  such  should  be  accounted  for  in  their  returns. 

Illustration 

As  an  illustration  of  the  above,  assume  that  Corpor- 
ation A  leases  its  plant  and  property  to  Corporation  B, 
under  which  arrangement  Corporation  B  is  to  pay  to  the 
stockholders  and  creditors  of  Corporation  A  a  dividend  on 
preferred  stock  of  2%  and  interest  on  accounts  payable 
amounting  to  $1,200,  together  with  taxes  or  other  fixed 
charges.  These  payments  are  considered  as  additional 
rental  and  should  be  returned  by  the  A  Corporation  as 
income  even  though  the  dividends  and  interest  are  paid 
by  the  B  Corporation  directly  to  the  bondholders  and  stock- 
holders of  the  A  Corporation.  Since  the  expenses  of  rental, 
taxes,  and  interest  (except  interest  on  inadmissibles)  are 
deductible  items  when  incurred  in  a  taxpayer's  business 
or  trade,  it  is  evident  that  the  above  expenses  when  thus 
paid  for  another  corporation  constitute  allowable  deduc- 
tions in  every  case  and  must  be  taken  into  consideration 
in  computing  its  net  income. 

Improvement  by  Lessee 

In  many  cases  where  the  lessee  enters  into  a  contract 
for  a  lease  of  land  an  arrangement  is  entered  into  whereby 
the  lessee  erects  thereon  a  building  which  reverts  to  the 
lessor  upon  the  expiration  of  the  lease.  Usually  the  build- 
ing erected  under  this  arrangement  is  not  subject  to  re- 
moval by  the  lessee. 

In  accordance  with  a  Circuit  Court  decision  of  the 
Ninth  District;  Miller  vs  Gearin,  258  Federal  225,  the  fol- 
lowing was  cited :  "Assuming  that  the  building  was  income 
derived  from  the  use  of  the  property  we  think  it  clear 
that  the  time  it  was  derived  was  the  time  when  the  com- 


INVESTED  CAPITAL  ACCOUNTING  49 

pleted  building  was  added  to  the  real  estate  and  enhanced 
its  value."  It  is  therefore  clear  that  if  a  building  is  erected 
on  leased  property  by  the  lessee  the  cost  of  the  building 
is  income  to  the  lessor  when  the  title  passes  to  the  lessor 
and  not  at  the  termination  of  the  lease. 

Proportion  of  Cost  to  be  Included  as  Income  to  Lessor 

Since  the  court  has  decided  that  the  cost  of  the  build- 
ing is  income  to  the  lessor  when  title  passes,  we  must 
ascertain  what  amount  of  the  cost  shall  be  included  as 
income  by  the  lessor.  In  view  of  the  fact  that  the  lessee 
retains  possession  of  the  property  during  the  life  of  the 
lease  it  is  evident  that  the  lessor  does  not  obtain  full  value 
at  the  time  the  title  passes. 

It  would  seem  only  equitable,  and  a  ruling  has  been 
so  promulgated  by  the  courts,  that  the  lessor  include  as 
income  only  the  depreciated  cost  value  of  the  building  as 
at  the  termination  of  the  lease;  that  is,  the  lessor  is 
allowed  to  deduct  the  amount  of  depreciation  which  would 
accrue  during  the  life  of  the  lease  as  soon  as  the  title  passes 
and  thus  include  as  income  only  the  net  value  of  the  building 
as  determined  by  the  life  of  the  building  and  the  length  of 
the  lease.  If  the  lease  extends  over  the  life  of  the  building 
no  income  will  be  realized  by  the  lessor  when  the  title 
passes,  since  the  depreciation  on  the  building  over  the 
life  of  the  lease  would  extinguish  its  entire  cost  before  the 
lease  expired.  The  following  extracts  are  taken  from  the 
ruling  laid  down  by  the  courts  which  clearly  interprets  this 
proposition : 

A,  in  1915,  leased  certain  land  to  B  for  twenty  years. 
B  agrees,  in  part  consideration  for  the  lease,  to  erect  on 
the  leased  ground,  a  building,  specifications  agreed  upon, 
of  an  estimated  life  of  twenty-five  years  and  to  cost  $50,000, 
which  building  is  not  to  be  subject  to  removal  by  B.  The 
building  is  completed  in  1920. 


50  INVESTED  CAPITAL  ACCOUNTING 

A  realizes  income  in  1920,  the  year  in  which  title  to 
the  building  passes.  The  measure  of  the  income  is  the 
present  value  to  A  of  the  building,  of  an  estimated  life  of 
twenty-five  years  and  cost  of  $50,000,  the  use  and  enjoy- 
ment of  which  is  postponed  for  fifteen  years.  Depreciated 
value  of  the  building  at  the  termination  of  the  period  of 
the  lease  will  be  approximately  $20,000 — that  is,  cost  less 
depreciation  sustained.  The  income  of  A,  then,  is  the  dis- 
count value  of  $20,000  receivable  at  the  end  of  fifteen  years. 

If  market  value  reflects  intrinsic  value  this  amount 
should  equal  the  difference  between  the  value  of  the  land 
free  from  the  lease  without  the  building  and  the  value 
of  the  land  subject  to  the  lease  with  the  building.  How- 
ever, any  other  evidence  available  should  be  considered  in 
determining  this  present  worth  to  the  taxpayer  of  the 
legal  title  to  the  encumbered  building. 

Since  A  has  included  in  income  only  the  depreciated 
value  of  the  building,  he  is  entitled  to  depreciation  deduc- 
tion with  respect  to  such  building  only  for  the  years  after 
the  termination  of  the  period  of  the  lease  when  A  has  come 
into  possession.  This  depreciation  deduction  to  which  A 
is  entitled  for  1935  and  subsequent  years  should  be  com- 
puted on  a  basis  of  the  estimated  remaining  life  of  the 
building  and  a  cost  value  equal  to  the  market  value  placed 
on  the  encumbered  building  by  A  in  the  year  of  its  erection, 
that  is,  the  annual  depreciation  for  1935  and  subsequent 
years  will  be  the  quotient  obtained  by  dividing  (a)  the 
value  of  the  improvements  to  A  as  determined  by  him  when 
the  same  building  became  part  of  the  realty  by  (b)  the 
number  of  years  in  the  estimated  remaining  life  of  the 
improvements  from  the  termination  of  the  lease. 

The  following  illustration  will  depict  the  working  of 
the  above  explanation  : 

Supposing  in  1920  Corporation  A  leases  a  parcel  of 


INVESTED  CAPITAL  ACCOUNTING  51 

land  from  Corporation  B  for  $10,000  for  ten  years  to  be 
paid  at  the  rate  of  $1,000  per  annum.  A  agrees  to  erect 
immediately  upon  this  land  a  building  costing  $20,000,  the 
life  of  which  is  estimated  at  twenty-five  years.  What  effect 
has  the  erection  of  the  building  upon  the  gross  income  of 
Corporation  B  ? 

Illustration 

Building  erected  in  1920  cost $20,000 

Life  of  building,  25  years,  which  determines 
depreciation  rate  of  4%  per  annum;  4%  of 
$20,000  =  $800  annual  depreciation. 
Total  depreciation  for  ten  years,  or  during  pe- 
riod of  lease 8,000 


Total  income  to  lessor  when  title  passes $20,000 

Less :  Total  depreciation  during  life  of  lease . .  8,000 

Depreciated  cost  of  building  to  Corporation  B 

in  1920 $12,000 


How  to  Determine  Amount  to  be  Included  as  Income  in  1920 

In  accordance  with  T.  D.  3062,  as  interpreted  in  Cumu- 
lative Bulletin  No.  4,  Ruling  8-21-1474  it  is  necessary  to 
compute  the  discounted  value  of  the  $12,000  receivable  at 
the  end  of  ten  years,  or  in  other  words,  to  determine  the 
amount  that  must  be  included  in  income  for  1920  that  will 
equal  $12,000  at  the  end  of  ten  years,  the  conclusion  of 
the  lease.  The  present  value  of  a  sum  due  at  a  fixed  future 
date  is  a  smaller  amount  which,  with  interest,  will  accu- 
mulate to  the  future  sum.  That  is,  the  present  value  of 
$12,000  due  in  ten  years,  say  at  6%,  is  a  sum  smaller  than 
$12,000,  which  with  interest  at  6%  compounded  for  ten 
years  will  accumulate  to  $12,000. 

In  order  to  demonstrate  the  principle,  and  as  an  illus- 
tration applicable  to  all  cases,  the  following  proposition 


52  INVESTED  CAPITAL  ACCOUNTING 

is  worked  out  on  the  basis  of  one  dollar  at  a  rate  of  6%. 
The  question  involved  is  to  determine  what  amount  at  the 
present  time  will  equal  one  dollar  at  the  end  of  ten  years 
at  6%  compound  interest. 

It  is  necessary  first  to  ascertain  what  will  be  the 
amount  of  one  dollar  at  the  end  of  ten  years  at  this  rate; 
that  is,  we  must  compute  the  amount  of  one  dollar  at  com- 
pound interest  at  6%  which  is  found  to  be  $1.79084770. 
This  amount  divided  into  $1  equals  $0.55839478,  the  dis- 
counted value  of  one'dollar,  or,  in  other  words,  the  amount 
which  is  required  at  the  present  time  to  equal  one  dollar  in 
ten  years  at  6%  compound  interest. 

After  the  discounted  value  or  present  worth  of  one 
dollar  is  obtained,  it  is  a  very  simple  matter  to  fincl  the 
discounted  value  of  any  other  amount  by  multiplying  this 
amount  by  the  amount  upon  which  the  present  worth  is 
desired.  Take  in  the  case  above  where  the  depreciated  cost 
of  the  building  is  found  to  be  $12,000  and  it  is  necessary 
to  compute  the  discounted  value,  or  rather  to  find  the 
amount  that  at  the  present  time  will  equal  $12,000  in  ten 
years.  The  first  step  is  to  determine  the  amount  of  one 
dollar  at  compound  interest,  at  the  prevailing  rate  (say 
6%),,  at  the  end  of  ten  years,  which  in  this  case  is  found 
to  be  $1.79084770.  This  amount  divided  into  one  dollar 
equals  $0.55839478,  the  discounted  value  or  present  worth 
of  one  dollar  as  at  the  beginning  of  the  first  year,  which 
multiplied  by  $12,000  equals  $6,700.74,  the  discounted  value 
of  $12,000  at  the  beginning  of  the  first  year,  receivable  at 
the  end  of  ten  years. 

During  the  first  year  the  accrued  income  earned  on 
account  of  the  discount  allowed  amounts  to  $402.04.  There- 
fore, the  correct  income  taxable  at  the  end  of  the  first 
year  is  the  sum  of  $6,700.74  plus  $402.04,  or  $7,102.78. 
Corporation  B  is  therefore  required  to  report  as  income 


INVESTED  CAPITAL  ACCOUNTING  53 

for  1920  $7,102.78  on  account  of  the  erection  of  the  building 
by  Corporation  A. 

Another  simple  method  of  determining  the  discounted 
value  of  the  above  $12,000  is  to  divide  the  amount  of  one 
dollar  at  compound  interest,  $1.79084770,  computed  as 
above,  into  the  $12,000,  which  equals  $6,700.74,  the  dis- 
counted value  of  $12,000. 

On  the  other  hand,  say  for  example,  that  the  lessee 
has  in  the  above  instance  acquired  the  lease  in  1916  and 
the  building  was  erected  in  1921.  How  will  this  affect  the 
income  of  the  lessor  corporation  ? 


Lease  acquired  in  1916  at  a  cost  of  $10,000 $10,000 

Building  erected  in  1921  at  a  cost  of  $20,000. .  20,000 
Annual  depreciation  on  building  at  4%,  $800. 
Remaining  life  of  lease  after  erection  of  build- 
ing 5  years. 

Total  depreciation  during  life  of  lease 4,000 

Total  income  to  lessor  when  title  passes  upon 

erection  of  building $20,000 

Less :  Total  depreciation  over  remaining  life  of 

lease    4,000 

Depreciated  cost  of  building  to  Corporation  B  

in  1920 $16,000 


In  this  case  the  amount  of  one  dollar  at  compound 
interest  at  6%  for  five  years  is  $1.33822558.  This  amount 
divided  into  $16,000  equals  $11,956.13  which  at  the  begin- 
ning of  the  year,  is  the  discounted  value  or  present  worth 
of  $16,000  receivable  at  the  end  of  five  years.  During  the 
first  year  the  amortized  discount  is  $717.37,  which  must 
be  added  to  the  above  amount,  making  $12,673.50,  total 
income  for  the  year.  Or  according  to  another  method  the 
discounted  value  or  present  worth  of  one  dollar  at  compound 
interest  at  6%,  which  is  $0.74725817,  multiplied  by  $16,000 


54  INVESTED  CAPITAL  ACCOUNTING 

equals  at  the  beginning  of  the  year,  $11,956.13,  the  dis- 
counted value  of  $16,000  receivable  at  the  end  of  the  period. 
This  amount  plus  the  amortized  discount  of  $717.37,  makes 
the  total  income  for  the  year  $12,673.50.  In  this  case  the 
lessor  corporation  should  report  as  income  for  1921  the 
sum  of  $12,673.50  on  account  of  the  erection  of  the  building 
by  the  lessee  corporation. 


Effect  of  Present  Worth  on  Subsequent  Years 

The  income  for  subsequent  years  in  such  instances  is 
affected  by  the  amount  of  the  increased  discounted  value 
for  each  succeeding  year  of  the  depreciated  cost  of  the 
building  as  at  the  termination  of  the  lease.  The  present 
worth  or  discounted  value  as  at  the  beginning  of  the 
first  year  of  $12,000  for  a  period  of  ten  years,  is  $6,700.74. 
During  the  first  year  the  accrued  income  earned  on  account 
of  the  discount  allowed  amounts  to  $402.04.  Therefore  the 
correct  income  taxable  at  the  end  of  the  first  year  is  the 
sum  of  $6,700.74  plus  $402.04,  or  $7,102.78. 

Since  the  depreciated  cost  of  the  building  at  the  ex- 
piration of  the  lease  is  $12,000,  but  only  $7,102.78,  the  dis- 
counted value  of  the  building  as  at  the  end  of  the  first 
year,  is  reported  as  income  for  the  first  year,  the  difference 
between  this  amount  and  the  depreciated  cost  of  the  build- 
ing as  at  the  expiration  of  the  lease  must  be  amortized 
over  the  remaining  life  of  the  lease  on  the  basis  of  the 
present  worth  of  the  depreciated  cost  of  the  building  for 
each  year  and  included  as  income.  The  amount  of  the  dis- 
count allowed  in  computing  the  present  worth  of  the  build- 
ing for  each  year  accrues  as  income  to  the  lessor  on  the 
basis  of  the  rate  per  cent  of  discount  used.  In  view  of 
the  fact  that  the  discounted  value  of  the  building  is  taken 
in  advance,  for  the  period  covering  the  life  of  the  lease, 
the  amount  of  this  discount  for  each  year  is  an  increment 


INVESTED  CAPITAL  ACCOUNTING 


55 


to  the  asset  value  of  the  lessor  and  must  be  considered 
as  income. 

An  illustration  of  this  proposition  based  on  6%  com- 
pound interest  for  a  period  of  ten  years,  is  computed  in  the 
following  manner: 


Number  of 

Present 

Amount  Receiv- 

Years Dis- 

Worth Be- 

End of 

able  at  End 

count  Com- 

ginning of 

Income 

Taxable 

of  lease 

pounded 

EachYear 

Realized 

Year 

$12,000 

10 

$6,700.74 

12,000 

9 

7,102.78 

$7,102.78 

1920 

12,000 

8 

7,528.95 

426.17 

1921 

12,000 

7 

7,980.69 

451.74 

1922 

12,000 

6 

8,459.53 

478.84 

1923 

12,000 

5 

8,967.10 

507.57 

1924 

12,000 

4 

9,505.12 

538.02 

1925 

12,000 

3 

10,075.43 

570.31 

1926 

12,000 

2 

10,679.95 

604.52 

1927 

12,000 

1 

11,320.75 

640.80 

1928 

12,000 

0 

679.25 

1929 

Total  income  realized 


$12,000.00 


Effect  of  Lease  Extending  Beyond  Life  of  Building 

If  the  term  of  the  lease  extends  through  or  beyond  the 
life  of  the  building  there  is  no  income  to  the  lessor  when 
the  title  passes,  since  there  would  be  no  value  remaining 
to  the  lessor  after  the  expiration  of  the  lease.  That  is, 
the  lessee  would  get  full  value  of  the  building  or  improve- 
ments during  his  possession  of  the  property.  The  income 
of  the  lessee  is  affected  by  leaseholds  in  that  it  is  an 
allowable  deduction  in  computing  net  income.  As  an  exam- 
ple, we  will  say  the  lessee  pays  $10,000  for  a  lease  for  ten 
years  paying  $1,000  per  annum.  This  $1,000  is  an  allow- 
able deduction  as  rental  each  year  at  arriving  at  net  income. 


56  INVESTED  CAPITAL  ACCOUNTING 

Furthermore,  if  the  lessee  erects  a  building  costing  $10,000 
on  property  leased  for  ten  years,  in  order  to  return  to  the 
lessee  his  investment  of  capital,  an  annual  deduction  may 
be  made  from  gross  income  of  $1,000  which  is  an  amount 
equal  to  the  total  cost  of  such  improvement  divided  by  the 
number  of  years  remaining  in  the  lease,  which  deduction 
should  be  in  lieu  of  a  deduction  for  depreciation. 

Income  of  Corporations  in  Liquidation 

A  corporation  may  liquidate  for  various  reasons.  The 
charter  may  expire  or  the  State  may  cancel  the  charter 
in  accordance  with  certain  rights  which  it  reserves  at  the 
time  of  issue.  A  corporation  may  surrender  its  charter. 
However,  the  most  common  reason  for  liquidating  is  in- 
solvency. This  usually  means  that  the  assets  of  a  cor- 
poration are  less  than  the  debts.  This  emphasizes  the 
economic  viewpoint  that  a  corporation  is  legally  insolvent 
when  the  cash  assets  are  not  sufficient  to  pay  the  debts 
when  they  become  due.  There  are  several  methods  of 
liquidation  which  are  usually  classed  as  follows : 

Bankruptcy 
Voluntary  Dissolution 
Receivership 

Usual  Method  Through  Receivership  (or  Trustee) 

If  a  corporation  has  been  operating  at  a  loss  and  finds 
that  it  is  necessary  to  dissolve,  the  usual  procedure  is  to 
turn  the  affairs  over  to  a  receiver  who  winds  up  the  business 
and  liquidates  the  capital.  When  a  corporation  is  obliged 
to  go  into  liquidation  the  corporate  existence  is  continued 
until  a  trustee  completes  the  liquidation  of  the  assets  and 
pays  the  debts.  The  trustee  in  this  way  stands  in  place 
of  the  corporation  to  conduct  its  business  and  is  required 
to  render  a  return  of  income  for  the  corporation.  As  prop- 


INVESTED  CAPITAL  ACCOUNTING  57 

erty  is  sold  by  the  receiver  (or  trustee)  any  gain  or  loss 
is  treated  by  the  receiver  (or  trustee)  in  the  same  manner 
as  if  handled  by  the  corporation  itself. 

The  trustee,  in  winding  up  the  affairs  of  an  insolvent 
corporation,  charges  himself  with  all  money  realized  by  the 
sale  of  the  assets  and  credits  himself  with  payments  for 
liquidating  the  liabilities  and  other  expenses,  including  his 
commission.  A  distinction  should  be  made  between  gain 
or  loss  in  the  sale  of  assets  or  property  and  a  liquidating 
dividend  which  represents  a  return  of  any  portion  of  the 
capital  to  its  stockholders.  In  other  words,  a  liquidating 
dividend  is  a  payment  to  the  stockholders  of  any  amount 
of  capital  invested  in  the  business.  However,  any  excess 
so  received  over  the  cost  of  his  stock  to  the  stockholder, 
or  over  its  fair  market  value  as  of  March  1, 1913,  if  acquired 
prior  thereto,  is  taxable  profit. 

Should  a  gain  be  made  in  the  sale  of  property,  as  in 
the  case  of  manufactured  articles,  this  should  be  included 
as  income  to  the  corporation. 


CHAPTER  FOUR* 

DEDUCTIONS  ALLOWED— BUSINESS  EXPENSES 
(SECTION  234) 

Deductions 

Statutory  deductions  are,  in  general,  though  not  ex- 
clusively, expenditures  other  than  capital  expenditures, 
connected  with  the  production  of  income.  This  practically 
established  the  fact  that  ordinarily  all  revenue  expenditures 
are  deductible  items  in  determining  net  income.  Revenue 
expenditures  are  what  has  been  expended  to  earn  income. 
That  is,  revenue  expenditures  may  be  said  to  be  the  generic 
term  including  cost,  expenses  and  losses  in  opposition  to 
income,  earnings  or  profit.  However,  there  are  a  few  ex- 
ceptions as  to  all  statutory  deductions  being  revenue  ex- 
penditures in  computing  net  income  for  tax  purposes,  and 
the  commercial  usage  of  revenue  expenditures  used  in  deter- 
mining net  income.  Take  for  instance  a  corporation,  in 
commercial  accounting,  customarily  considers  charitable 
contributions,  advertising  (other  than  of  trade  advertising) 
and  contributions  for  campaign  expenses  as  ordinary  rev- 
enue expenditures.  While,  technically  speaking,  this  is 
correct  in  commercial  usage,  these  items  are  not  deductible 
from  gross  income  in  computing  net  taxable  income.  Tax- 
able net  income  is  wholly  a  statutory  conception  but  with 
a  few  modifications  in  making  deductions  and  the  statutory 
exemptions,  it  follows  the  usual  lines  of  commercial  net 


"This  chapter  is  from  the  pen  of  Mr.  John  M.  Hartman,  Assistant 
Chief,  Training  Section,  Income  Tax  Unit. 


INVESTED  CAPITAL  ACCOUNTING  59 

income.  This  is  to  be  assumed  and  only  reasonable,  since 
it  is  ordinarily  computed  upon  the  same  basis  and  in  accord- 
ance with  the  same  methods  of  accounting  as  generally 
employed  in  all  commercial  corporation  accounting. 

When  Allowable 

All  ordinary  and  necessary  expenses  known  as  "busi- 
ness expenses"  in  order  to  be  deductible,  must  be  for  the 
year  in  which  paid  or  incurred.  In  the  case  of  a  corpo- 
ration making  a  return  on  an  accrual  basis,  it  may  deduct 
all  authorized  allowances  whether  paid  in  cash  or  set  up 
as  a  liability.  This  is  equivalent  to  the  fact  that  if  the 
corporation  does  not  pay  or  accrue  within  any  year  certain 
of  its  expenses,  nor  take  them  as  a  deduction,  it  cannot 
for  the  next  or  any  subsequent  year  make  a  deduction  from 
income  of  any  such  amounts  which  are  later  paid  in  the 
liquidation  of  such  prior  year's  liabilities  or  expenses. 

Period  Covered 

The  law  requires  that  a  corporation  make  its  return 
for  each  year  complete  in  itself,  so  far  as  practicable, 
both  as  to  gross  income  and  the  proper  deductions  taken. 

Failure  to  Charge  off  the  Books 

Let  us  assume,  for  example,  that  a  corporation  in 

1918  has  an  expense  item  of  $200  for  incidental  repairs, 
which  through  a  bookkeeping  error  was  not  charged  off  on 
the  books,  and  consequently  not  taken  as  a  deduction.    In 

1919  they  discover  the  error  and  charge  off  this  amount 
on  their  books  and  deduct  it  in  their  1919  return.    Would 
this  be  allowable  ?    No.    Since  this  is  not  an  allowable  deduc- 
tion in  computing  income  for  the  current  year  this  amount 
must  be  added  back  to  the  book  income  in  computing  cur- 
rent net  income  for  1919.     However,  in  case  a  taxpayer 
discovers  subsequent  to  its  occurrence  the  amount  of  the 
loss  sustained  during  the  prior  taxable  year,  which  has 


60  INVESTED  CAPITAL  ACCOUNTING 

not  been  deducted  from  the  gross  income  of  the  prior  year, 
he  may  render  an  amended  return  for  such  preceding 
taxable  year  and  include  the  amount  of  such  loss  in  the 
deductions  from  gross  income  for  the  year  in  question. 
In  this  event  a  claim  for  refund  must  be  filed  for  the  excess 
of  tax  paid  on  account  of  the  excessive  income  reported 
upon  which  tax  was  paid  for  the  year  that  such  loss  should 
have  been  deducted. 

Embezzlement  and  Suit  for  Judgment 

Take  another  case  where  a  corporation  lost  $5,000  on 
account  of  embezzlement  in  1918,  but  does  not  discover 
this  fact  until  1921.  It  cannot  deduct  this  amount  from 
gross  income  in  computing  its  1921  net  income.  In  order 
to  secure  relief  in  this  instance  it  would  be  necessary  to 
file  an  amended  return  and  claim  this  amount  as  a  deduc- 
tion in  its  1918  return.  However,  any  amount  paid  pur- 
suant to  judgment  or  otherwise  on  account  of  a  patent 
infringement  or  otherwise,  is  deductible  from  gross  income 
when  the  claim  is  put  in  judgment  or  paid,  and  not  when 
the  suit  is  instituted. 

Let  us  assume  that  a  case  was  taken  to  court  for  relief 
on  account  of  infringement  of  patent  for  $10,000  in  1918 
and  remained  in  the  courts  until  1920,  when  judgment  was 
rendered  for  $5,000,  but  not  paid  until  1921.  In  computing 
net  income  the  question  arises  as  to  what  amount  would 
be  deductible  and  when.  In  this  case  the  proper  amount 
deductible  in  computing  net  income  would  be  $5,000  for 
the  year  1920  when  the  judgment  is  rendered. 

Any  expense  in  connection  with  a  suit  of  this  kind, 
however,  would  be  deductible  for  the  year  in  which  in- 
curred. That  is,  expenses  of  prosecution,  such  as  attorney 
fees,  witness  fees,  or  other  expenses,  are  deductible  in 
the  year  when  incurred  or  paid,  even  though  no  judgment 
is  rendered  during  the  year  of  such  expense,  but  in  a  sub- 


INVESTED  CAPITAL  ACCOUNTING  61 

sequent  year.  Remember,  that  the  amount  of  any  judg- 
ment is  deductible  only  for  the  year  in  which  the  judgment 
is  rendered. 

There  are  a  few  somewhat  unusual  expenses  which 

are  considered  as  "business  expenses,"  among  which  are 

the  following:  Penalty  for  filing  delinquent  tax  returns, 

entertainment  expenses  and  subscriptions  to  business 
magazines. 

Business  Expenses 

Under  the  Revenue  Act  of  1918,  there  are  a  great 
number  and  variety  of  items  included  under  "business  ex- 
penses." Business  expenses  may  be  taken  as  deductions 
either  by  subtracting  from  the  total  receipts  in  computing 
gross  income  or  deducting  directly  from  gross  income  in 
determining  net  income.  Business  expenses  include  all 
items  entering  into  what  is  ordinarily  known  as  the  "cost 
of  goods  sold"  along  with  selling  and  management  expense, 
but  does  not  include  the  following  items  which  are  treated 
separately:  Taxes,  losses,  bad  debts,  depreciation,  amor- 
tization, depletion,  charitable  contributions  and  loss  in  in- 
ventory. The  items  that  are  to  be  considered  as  business 
expenses  may  be  classed  as  follows:  Material,  labor,  sup- 
plies, repairs  (in  case  of  manufacturing),  goods  bought  for 
resale,  reasonable  compensation  for  services  of  officers, 
advertising  and  other  selling  expenses,  insurance  premiums 
against  fire,  storms,  theft,  accident,  or  other  similar  losses, 
and  rental  for  use  of  business  property.  As  a  matter  of 
fact,  any  deductions,  except  as  noted  above,  may  be  taken 
by  a  taxpayer  if  the  expense  is  incurred  in  carrying  on  his 
trade  or  business. 

Cost  of  Material 

In  computing  the  cost  of  material,  the  charges  usually 
include  only  the  amount  that  was  consumed  in  operation 


62  INVESTED  CAPITAL  ACCOUNTING 

during  the  year  for  which  the  return  is  made.  The  cost 
of  material  is  properly  ascertained  by  the  inventory  method 
which  includes  the  consumption  of  goods  as  reflected  by 
the  inventories  taken  at  the  beginning  and  end  of  the  year, 
as  the  following  illustration  indicates: 


Inventories  at  beginning  of  year 

(To  be  reconciled  with  balance  sheet) 
Purchases  during  the  year 


Labor  and  wages  ordinarily  charged  to  man- 
ufacturing    $20,000 

Other  expenses  ordinarily  charged  to  man- 
ufacturing          3,000      23,000 


Total    $80,000 

Inventory   at   end   of   year 30,000 

Cost  of  goods  sold $50,000 


Repairs 

The  principal  reason  for  repairing  plant  or  machinery 
is  to  keep  them  in  working  condition.  Repairs  in  the  nature 
of  replacements  to  the  extent  that  they  arrest  depreciation 
and  appreciably  prolong  the  life  of  the  property  should  be 
charged  against  a  depreciation  reserve.  Any  expense  which 
in  any  way  increases  the  utility  of  the  machinery  should 
be  charged  to  a  capital  account.  It  is  sometimes  difficult 
to  distinguish  between  ordinary  repairs  which  are  necessary 
to  keep  machinery  in  good  running  condition,  and  other 
expenditures  (sometimes  called  repairs)  which  are  in  reality 
improvements,  or  capital  expenditures,  to  the  extent  that 
they  arrest  depreciation  and  which  should  be  charged 
against  a  depreciation  reserve. 


INVESTED  CAPITAL  ACCOUNTING  63 

Illustration 

Let  us  assume  that  an  expenditure  is  made  for  a  new 
cylinder,  a  gasket,  or  for  grinding  the  valves  of  an  auto- 
mobile, costing  from  $3  to  $5,  which  adds  simply  to  the 
upkeep  of  the  machine  and  maintains  it  in  a  proper  run- 
ning condition.  This  is  purely  an  expense  for  repairs.  On 
the  other  hand,  let  us  assume  that  an  expenditure  is  made 
for  automobile  bumpers,  chains  or  some  other  special 
attachment  costing  from  $20  to  $50,  which  adds  to  the 
value  of  the  machine.  This  is  considered  a  capital  expend- 
iture. When  an  expense  for  repairs,  so  called,  has  in- 
creased the  efficiency  of  the  plant  or  machine,  such  an 
expense  should  be  appropriately  capitalized,  but  if  the  ex- 
penditure has  not  increased  the  output  of  the  machinery 
but  has  only  kept  it  at  its  previously  stated  efficiency,  the 
value  of  the  machine  has  in  no  sense  been  increased,  and 
the  expenditure  would  be  chargeable  to  revenue  or  repairs. 

Professional  Expenses 

A  great  many  corporations  are  members  of  trade  socie- 
ties and  organizations  interested  in  the  principal  trade  or 
business  in  which  the  corporation  is  engaged,  such  as 
manufacturers'  associations,  furniture  dealers'  associations 
and  numerous  other  combines  of  the  same  character.  Cor- 
porations that  are  members  of  such  societies  are  required 
to  pay  certain  membership  fees  and  annual  dues.  Expenses 
of  this  nature  are  business  expenses  and  allowable  de- 
ductions. 

Illustration 

Say  a  corporation  pays  $25  per  annum  dues  to  an 
engineering  society  and  also  purchases  a  set  of  engineering 
books  for  use  in  its  office.  The  amount  paid  for  dues  for 
membership  in  the  society  is  a  deductible  item,  while  the 
cost  of  the  books  is  a  capital  expenditure. 


64  INVESTED  CAPITAL  ACCOUNTING 

Any  expense  which  may  be  necessary  in  carrying  on 
the  business  along  professional  lines  or  of  the  trade  or 
business,  such  as  subscriptions  to  magazines  which  are 
used  in  the  business,  are  deductible.  However,  no  amounts 
expended  in  a  professional  way  for  equipment,  books,  fur- 
niture, etc.,  of  a  permanent  character,  are  allowable  de- 
ductions. 

Compensation  for  Personal  Services 

Illustration  where  Payments  for  Compensation  are  Reason- 
able and  for  Personal  Services  Actually  Rendered. 

When  Salaries  and  Other  Compensation  Deductible 

Salaries  or  other  compensation  for  personal  services 
incurred  in  carrying  on  any  trade  or  business  may  be  in- 
cluded at  a  reasonable  allowance.  A  test  further  in  case 
of  compensation  as  to  its  deductibility  is  whether  it  is 
reasonable  and  if  the  payments  are  purely  for  services  ren- 
dered. The  form  or  method  of  fixing  compensation  is  not 
decisive  as  to  deductibility. 

While  any  form  of  contingent  compensation  invites 
scrutiny  as  a  possible  distribution  of  earnings  of  the  enter- 
prise, it  does  not  follow  that  payments  on  a  contingent 
basis  are  to  be  treated  fundamentally  on  any  basis  different 
from  that  applying  to  compensation  at  a  flat  rate.  Services 
of  an  individual  for  payment  not  pursuant  to  a  free  bargain 
made  before  the  services  are  rendered  and  not  influenced 
by  any  consideration  on  the  part  of  the  employee  other 
than  that  of  securing  the  service  on  fair  and  advantageous 
terms  shall  be  allowed  as  a  deduction  even  though  in  the 
actual  working  out  of  the  contract  it  may  prove  to  be 
greater  than  the  amount  which  was  ordinarily  to  be  paid. 

In  any  event,  the  allowance  for  compensation  paid  may 
not  exceed  what  is  reasonable  in  all  circumstances.  It  is, 


INVESTED  CAPITAL  ACCOUNTING  65 

in  general,  just  to  assume  that  reasonable  and  true  com- 
pensation is  only  such  an  amount  as  would  ordinarily  be 
paid  for  like  services  by  like  enterprises  in  like  circum- 
stances, such  circumstances  to  be  taken  into  consideration, 
or  those  existing  at  the  date  when  the  contract  for  the 
services  was  made  and  not  those  existing  at  the  date  when 
the  contract  is  questioned.  Where  no  determination  of 
compensation  is  had  until  the  completion  of  the  service, 
the  amount  received  is  income  for  the  taxable  year  of  its 
determination  if  the  return  is  rendered  on  the  accrual  basis. 

In  determining  a  reasonable  compensation  for  officers 
of  a  corporation,  the  averages  as  compiled  in  Bureau  of 
Internal  Revenue  Bulletin  "Average  Percentages  of  Net 
Income  to  Gross  Income,"  may  be  used,  which  gives  a  com- 
parison with  similar  average  percentages  of  net  income  to 
gross  income  returned  by  concerns  engaged  in  like  busi- 
nesses. The  formula  given  in  this  bulletin  follows: 

Gross  income  returned  by  the  taxpayer,  times  average 
percentage  of  net  income  to  gross  income  equals  net  income 
that  should  have  been  returned  by  the  taxpayer. 

Net  income  returned  by  the  taxpayer  plus  compen- 
sation deducted  minus  net  income  that  should  have  been 
returned  by  the  taxpayer,  equals  compensation  allowable. 

There  is,  however,  no  hard  and  fast  rule  that  can  be 
applied  for  the  determination  of  the  amount  that  should 
be  considered  reasonable  compensation  in  every  instance. 
Moreover,  the  comparatives  as  shown  in  this  Bulletin  are 
not  to  be  followed  in  all  cases  but  may  be  disregarded  if 
the  circumstances  in  any  case  are  so  extraordinary  as  to 
make  it  clear  that  the  corporation  in  question  cannot  prop- 
erly be  considered  as  comparable  with  other  corporations 
of  the  same  class  to  which  it  naturally  belongs. 


66  INVESTED  CAPITAL  ACCOUNTING 

Illustration  where  Payments  for  Compensation  for  Per- 
sonal Services  are  not  Purely  for  Services  Rendered. 

(a)  Sometimes  amounts  are  paid  in  the  form  of  com- 
pensation but  are    not  in  reality  the    purchase  price  of 
services.    Such  items  are  not  deductible. 

Illustration 

A  corporation  is  paying  an  officer  of  its  company  a 
salary  of  $5,000  per  annum  on  a  calendar  year  basis  for 
services  as  secretary  of  the  corporation.  This  officer  finds 
that  in  October  he  has  some  personal  affairs  to  attend  to 
and  takes  furlough  for  the  balance  of  the  calendar  year. 
The  corporation,  in  consideration  of  his  faithfulness  in 
the  past,  decided  that  it  will  pay  his  full  salary,  and  deduct 
the  total  amount  of  such  salary  in  computing  net  income. 
Would  this  be  allowed  as  a  deduction?  No,  since  it  does 
not  represent  the  purchase  price  for  services  rendered.  The 
correct  amount  deductible  would  be  $3,750. 

Furthermore,  salaries  can  be  deducted  only  for  the 
year  in  which  the  service  is  rendered.  That  is,  a  deduction 
claimed  for  salaries  in  1920  for  services  rendered  in  1918 
is  not  allowable. 

(b)  An  ostensible  salary  paid  by  a  corporation  may 
be  a  distribution  of  a  dividend  on  stock. 

Supposing  a  corporation  having  only  a  few  stockholders 
practically  all  of  whom  draw  salaries,  pays  excessive 
amounts  as  salaries,  it  would  appear  that  the  salaries,  if 
in  excess  of  those  ordinarily  paid  for  the  same  service,  are 
not  paid  wholly  for  the  service  rendered,  but  in  part  as  a 
distribution  of  earnings. 

Illustration 

This  could  occur  in  case  of  a  close  corporation,  which 
we  will  say  is  composed  of  three  stockholders  who  are  also 
the  officers  of  the  corporation;  president,  treasurer  and 


INVESTED  CAPITAL  ACCOUNTING  67 

secretary,  each  holding  $15,000  worth  of  stock.  The  cor- 
poration reported  a  net  income  for  the  taxable  year  of 
$12,000,  but  it  is  discovered  in  auditing  its  return  that  it 
has  deducted  for  salaries  $18,000.  This  deduction  is,  of 
course,  out  of  all  proportion  to  the  correct  amount  deductible 
for  a  corporation  of  this  amount  of  capitalization  and  would 
indicate  that  part  of  the  earnings  are  being  distributed 
upon  the  stock  held  and  a  salary  deduction  should  therefore 
be  allowed  commensurate  with  the  amount  of  business  and 
capitalization  as  compared  to  other  corporations,  in  accord- 
ance with  the  comparative  salary  table  referred  to  pre- 
viously. 

(c)  An  ostensible  salary  paid  by  a  corporation  may 
be  in  part  a  waste  or  appropriation  of  assets  of  the  cor- 
poration. Where  salaried  employees  are  in  control  of  the 
corporation  and  are  either  holding  directly  or  indirectly  a 
majority  of  its  stock  or  in  case  of  a  large  corporation  with 
many  stockholders  owning  a  substantial  minority  of  its 
stock,  the  tendency  is  to  inflate  salaries. 


Illustration 

Let  us  suppose  that  a  corporation  is  operating  at  a 
very  small  profit,  and  it  decides  that  its  officers  should 
receive  a  large  salary,  regardless  of  its  earnings.  It  man- 
aged to  dispose  of  some  of  its  assets  and  this  was  returned 
as  paid  out  in  salaries,  which  as  a  matter  of  fact  is  nothing 
more  than  a  liquidation  of  capital  paid  to  its  officers  as 
salary.  A  close  analysis  of  the  balance  sheets  would  reveal 
the  condition  carried  on  in  this  manner  and  the  proper 
salary  adjustments  should  be  made. 

(d)  An  ostensible  salary  may  be  part  payment  for 
property.  Let  us  assume  a  case  where  officers  continue 
in  the  service  of  a  corporation  where  a  partnership  sells 
out  to  a  corporation.  It  might  be  found  in  such  an  instance 


68  INVESTED  CAPITAL  ACCOUNTING 

that  the  salaries  constitute  payment  for  the  transfer  of 
their  business. 

Treatment  of  Excessive  Compensation 

When  amounts  are  ostensibly  paid  as  compensation 
but  not  allowed,  their  treatment  can  usually  be  determined 
in  the  following  manner: 

If  the  payments  correspond  or  bear  a  close  relation- 
ship to  stockholders,  the  amount  of  the  excess  should  be 
treated  as  a  dividend. 

If  such  payments  represent  an  appropriation  of  assets 
of  the  corporation  by  the  officers  who  control  it,  and  fix 
their  compensation  in  violation  of  the  rights  of  the  corpo- 
ration, the  amount  of  excess,  while  disallowed  as  a  deduc- 
tion by  the  corporation,  should  be  treated  as  compensation 
of  the  individuals  subject  to  the  normal  tax. 

If  excessive  compensation  is  paid  and  such  payments 
constitute  in  part  payment  for  property,  the  amount  of 
the  excess  should  be  treated  by  the  corporation  as  a  capital 
expenditure. 

Compensation  Paid  Other  Than  Cash 

Sometimes  it  may  be  desirable  for  a  corporation  to 
pay  for  services  rendered  with  something  other  than  cash. 
This  is  permissible,  but  in  determining  what  amount  should 
be  allowed  for  services  rendered  when  paid  for  in  this  way, 
the  fair  market  value  of  the  thing  taken  in  payment  must 
be  considered  as  the  amount  of  compensation  paid.  Fur- 
thermore, it  is  presumed  that  the  compensation  received  is 
the  fair  value  for  such  services  if  the  services  were  ren- 
dered at  a  stipulated  price.  A  corporation  may  desire  to 
pay  compensation  to  an  employee  in  stock  in  which  case 
the  amount  of  compensation  is  determined  by  the  market 
value  of  the  stock  as  if  sold  by  the  corporation  and  the 


INVESTED  CAPITAL  ACCOUNTING  69 

employee  paid  in  cash.  Where  living  quarters,  such  as_a 
camp,  is  furnished  an  employee  for  the  convenience  of  the 
employer,  the  ratable  value  should  not  be  considered  as 
cash  compensation  to  the  employee,  but  if  the  employee 
is  furnished  living  quarters  in  addition  to  salary  for  services 
rendered,  the  value  of  such  living  quarters  furnished  con- 
stitutes an  allowable  deduction  in  the  way  of  additional 
compensation. 

If  a  corporation  should  pay  an  employee  in  land  for 
services  rendered  in  1919,  the  title  to  which  might  be  in 
dispute  and  in  1920  the  title  adjudged  to  be  valid,  con- 
stitutes a  deduction  for  compensation  only  in  1919. 

Bonuses  to  Employees 

Bonuses  paid  in  good  faith  and  as  an  additional  com- 
pensation for  services  actually  rendered  by  employees,  pro- 
vided such  payments  when  added  to  the  stipulated  salaries 
do  not  exceed  reasonable  compensation  for  services  ren- 
dered, constitute  allowable  deductions  from  gross  income. 

Illustration 

Let  us  suppose  that  a  corporation  pays  its  secretary 
$2,000  per  annum,  but  owing  to  a  great  deal  of  extra  work 
done  in  evenings  and  on  some  holidays,  they  decide  at  the 
end  of  the  year  to  pay  him  an  additional  sum  of  $500  for 
this  special  service.  This  additional  compensation  paid 
would  be  an  allowable  deduction.  Again,  let  us  suppose 
that  an  employee  works  by  piece  work  and  is  paid  at  the 
rate  of  $6  for  finishing  and  riveting  600  grain  drill  plates 
per  day,  and  a  quarter  of  a  cent  bonus  on  all  over  600. 
At  the  end  of  the  year  the  additional  compensation  so  paid 
to  all  employees  amounts  to  $2,000.  This  would  properly 
be  an  allowable  deduction  from  gross  income. 

However,  let  us  suppose  in  case  of  the  secretary  of  the 


70  INVESTED  CAPITAL  ACCOUNTING 

corporation,  who  is  paid  $2,000  per  year,  that  the  corpo- 
ration desires  to  reward  him  in  some  manner  and  decides 
to  present  him  with  a  purse  of  $200  as  a  gift.  Such  an 
expense  or  bonus  cannot  be  taken  as  a  deduction  in  com- 
puting net  income,  since  it  is  in  the  nature  of  a  donation, 
as  no  commensurate  service  has  been  rendered.  It  does 
not  have  the  element  of  compensation  and  should  be  con- 
sidered as  in  excess  of  reasonable  compensation  for  services 
rendered.  Such  payments  as  these  are  in  the  nature  of 
gratuities  and  not  deductible  from  gross  income. 

Pensions 

Pensions,  when  paid  to  retired  employees  or  their 
families,  or  others  dependent  on  them,  on  account  of  in- 
juries received,  and  lump  sum  amounts  paid  as  compensa- 
tion for  injuries  are  considered  as  proper  deductions  as 
ordinary  expenses.  Such  amounts  are  limited  to  the  amount 
not  compensated  for  by  insurance  or  otherwise.  In  case 
a  corporation  sets  aside  or  contributes  a  certain  amount 
each  year  to  a  fund  called  a  "pension  fund"  which  is  held 
by  the  corporation,  the  amount  so  contributed  is  not  de- 
ductible in  this  case,  but  the  amount  actually  paid  to  the 
employee  is  deductible. 

Illustration 

Supposing  a  corporation  contributes  each  year  $500 
to  a  fund  for  pensions  and  during  the  year  it  paid  to  dis- 
abled or  retired  employees  $300  of  this  amount.  The 
amount  actually  paid  out  to  the  employees,  $300,  is  de- 
ductible from  gross  income  while  the  amount  contributed 
to  the  fund  is  not  deductible. 

Rentals 

A  corporation  acquires  a  leasehold  on  certain  property 
for  $10,000  for  a  period  of  ten  years  for  which  it  pays 


INVESTED  CAPITAL  ACCOUNTING  71 

at  the  rate  of  $1,000  per  annum.  This  amount  for  each 
year,  over  the  term  of  the  lease,  is  an  allowable  deduction. 
On  the  other  hand,  say  the  amount  of  the  lease  is  paid 
for  the  full  amount  of  $10,000  at  the  time  of  acquiring  the 
lease.  The  amount  deductible  isv  still  only  the  aliquot  part 
of  such  sum  each  year  based  on  the  number  of  years  the 
lease  is  to  run.  If  any  taxes  are  paid  by  the  tenant  to 
or  for  the  lessor,  this  constitutes  additional  rent  and  is  a 
deductible  item  to  the  lessee.  Where  the  lessee  erects  a 
building  or  makes  permanent  improvements  on  leased 
ground,  the  costs  of  such  buildings  or  improvements  are 
held  to  be  capital  investments  and  not  deductible  as  busi- 
ness expenses.  However,  in  order  to  return  to  the  lessee 
his  investment  of  capital,  an  annual  deduction  may  be  made 
from  gross  income  of  an  amount  equal  to  the  total  cost 
of  such  buildings  or  improvements  divided  by  the  number 
of  years  remaining  of  the  term  of  the  lease  and  such  deduc- 
tions shall  be  in  lieu  of  a  deduction  for  depreciation.  If 
the  remainder  of  the  term  of  the  lease  is  greater  than  the 
probable  life  of  the  buildings  or  improvements,  the  deduc- 
tion should  take  the  form  of  an  allowance  for  depreciation. 


Illustration 

Let  us  assume  that  the  lessee  erects  a  building  that 
cost  $20,000  on  a  piece  of  land  leased  for  ten  years.  In 
order  to  obtain  relief  and  a  return  of  his  capital  he  deducts 
for  each  year  the  amount  of  $2,000  during  the  life  of  the 
lease,  which  deduction  shall  be  in  lieu  of  depreciation.  How- 
ever, in  case  where  a  lease  runs  for  30  years  and  the 
buildings  erected  thereon  have  a  life  of  only  25  years,  then 
the  deduction  shall  be  taken  as  depreciation  over  the  life 
of  the  buildings.  Thus  in  the  above  case  depreciation  would 
be  deductible  at  the  rate  of  4%  per  annum  based  on  the  cost 
of  the  buildings. 


72  INVESTED  CAPITAL  ACCOUNTING 

All  rentals  for  business  property  are  deductible  unless 
such  rental  is  for  property  on  which  the  taxpayer  has  taken 
or  is  taking  title,  or  in  which  he  has  an  equity.  However, 
rental  for  personal  property  is  not  deductible. 


CHAPTER  FIVE 

CORPORATION  BONDS— GAIN  OR  LOSS 
I.   Corporation  Bonds 

Illustrating  Article  544 

(1-a)  If  bonds  are  issued  at  face  value,  that  is,  if 
a  corporation  receives  an  amount  for  the  bond  that  would 
be  just  sufficient  to  redeem  it  (say  it  receives  $100  for  a 
bond,  the  face  value  of  which  is  $100),  no  gain  is  realized; 
neither  is  any  loss  suffered. 

To  illustrate  each  of  the  other  subdivisions  of  this 
article,  we  will  assume  that  the  Simpson  Company  issued 
four  different  series  of  bonds,  each  series  amounting  to 
$10,000,  and  that  the  various  shares  brought  variant  prices, 
and  (or)  that  the  bonds  were  redeemed  at  prices  different 
from  the  value  received  at  the  time  of  the  sale.  Also  the 
life  of  all  bonds  is  assumed  to  be  ten  years  and  the  interest 
rate  is  5^>. 

(1-b)  Series  "A"  bonds  were  issued  at  face  value  Jan- 
uary 2,  1913.  At  January  2,  1918,  the  bonds  are  purchased 
and  retired,  the  purchasing  price  being  104. 


Bonds  cost  the  company $10,400 

Company  received  for  the  issue 10,000 

Amount  deductible  in  1918..  .  .$      400 


(1-c)     Series  "B"  bonds  were  issued  at  face  value 


74  INVESTED  CAPITAL  ACCOUNTING 

January  2,  1913.    At  January  2,  1918,  the  bonds  are  pur- 
chased at  98  and  retired. 

Company  received  for  the  issue $10,000 

Bonds  cost  the  company 9,800 

Taxable  income  for  1918..  ..$      200 


(2-a)   Series  "C"  bonds  were  sold  January  2,  1918, 
at  105. 

Total  amount  received  by  the  company ...$10,500 

Face  value  of  the  bonds 10,000 

Taxable  income  to  be  amortized $      500 


Of  the  $500  taxable  income,  $50  must  be  reported  in 
each  of  the  ten  years  representing  the  life  of  the  bonds. 

(2-b)    Series  "C"  bonds  were  purchased  January  2, 
1920,  at  106  and  retired. 


Cost  to  retire  the  bonds $10,600 

Issuing    price $10,500 

Less  amount  returned  as  income  (2  years) .        100  10,400 

Expense  deductible  for  1920 $      200 


Or  (2-c)  Series  "C"  bonds  were  purchased  January  2. 
1920,  at  100  and  retired. 

Issuing  price $10,500 

Less  amount  returned  as  income   (2  years) 100 

$10,400 
Cost  to  retire  bonds 10,000 

Taxable  income  for  1920 $      400 


INVESTED  CAPITAL  ACCOUNTING  75 

Series  "D"  bonds  were  issued  at  a  discount  of 
January  2,  1918. 

Face  value  of  bonds $10,000 

Issuing  price 9,000 

Amount  of  discount  to  be  amortized $  1,000 


Each  year  during  the  life  of  the  bonds,  $100  may  be 
deducted  from  gross  income  as  representing  what  is  in 
effect  additional  interest.  It  is  evident  that  the  purchaser 
receives  actually  not  5%  on  his  investment,  but  a  rate  con- 
siderably higher,  for  on  each  $90  he  invested  in  a  bond, 
he  receives  $5  in  interest,  or  a  rate  of  .05555,  plus  a  portion 
of  the  $1,000  he  will  receive  at  maturity  of  the  bonds  in 
addition  to  what  he  paid  for  them. 

(3~b)  At  January  2,  1920,  the  company  purchased  the 
above  bonds  at  face  value  and  retired  them. 


Issuing  price $9,000 

Amount  amortized  over  two-year  period 200 

$  9,200 
Cost  to  retire  the  issue 10,000 

Amount  deductible  in  taxable   (1920)  year $     800 


Or,  (3-c)  January  2,  1920,  the  company  purchased  and 
retired  the  above  bonds  paying  therefor  $8,500. 

Issuing  price $9,000 

Amount   amortized 200 

$9,200 
Cost  to  retire  the  issue 8,500 

Taxable  income  for  1920. .  .  .$    700 


76  INVESTED  CAPITAL  ACCOUNTING 

A  study  of  the  foregoing  illustrations  will  disclose  the 
fact  that  the  whole  matter  of  computing  gain  or  loss  on 
transactions  involving  bond  issues  and  retirements  may  be 
reduced  to  two  general  rules : 

1.  The  difference  between  the  face  value  and  the  sale 
price  is  to  be  divided  by  the  number  of  years  that 
the  bonds  are  to  run  and  this  quotient  is  taxable 
each  year  during  the  life  of  the  bonds  provided  the 
bonds  sold  above  face  value ;  or,  if  sold  below  face 
value,  the  amount  represented  by  the  quotient  is 
deductible  from  gross  income  each  taxable  year 
during  the  life  of  the  bonds. 

2.  (a)  Bonds  sold  at  par  value  if  retired  at  a  price 
different  from  that  value,  the  difference  is  gain  or 
loss,  according  as  they  were  retired  for  more  or 
less  than  the  face  value. 

(b)  When  bonds,  for  which  premium  or  discount  has 
been  amortized,  are  redeemed  at  a  price  differing 
from  the  issuing  price,  the  difference  is  loss  or 
gain,  depending  upon  whether  more  or  less  was 
paid  for  them  than  was  originally  received.  In 
the  event  of  loss,  we  deduct  from  the  loss  the 
amount  already  amortized  (since  this  loss  was 
allowed  in  the  amortization  charges) .  In  the  case 
of  gain,  we  deduct  from  the  gain  the  amount  al- 
ready returned  as  income  through  amortization. 

It  should  be  noted  particularly  that  in  the  cases  where 
bonds  are  sold  at  a  premium  or  at  a  discount,  the  total 
premium  or  discount,  as  the  case  may  be,  must  be  spread 
over  the  entire  period  of  years  representing  the  life  of  the 
bonds — in  other  words,  the  premium  or  discount  must  be 
amortized,  crediting  or  charging  Profit  and  Loss  each  year 
with  its  prorated  amount  of  income  or  expense  (deduc- 
tion). In  cases  where  the  bonds  are  retired,  the  entire 


INVESTED  CAPITAL  ACCOUNTING  77 

gain,  if  any,  is  income  for  the  taxable  year,  and  the  entire 
loss,  if  any,  is  a  deductible  item  for  the  taxable  year.  Of 
course,  if  only  a  part  of  an  issue  were  retired,  the  gain 
or  loss  would  be  computed  only  upon  the  amount  retired, 
and  the  amortization  of  gain  or  loss  on  the  unretired  amount 
of  bonds  would  be  continued  just  the  same  as  before. 


II.  Gain  or  Loss 

1.  The  basis  for  determining  gain  or  loss  from  the 
sale  or  exchange  of  property  is  cost.    If  the  property  was 
acquired  on  or  after  March  1,  1913,  the  basis  is  its  cost  or 
its  approved  inventory  value  as  determined  in  accordance 
with  Section  203. 

2.  (a)  Where  the  fair  market  value  of  property  as 
at  March  1,  1913,  is  in  excess  of  its  cost,  the  gain  to  be 
included  as  income  is  the  excess  of  the  sale  price  over  the 
fair  market  value  as  at  March  1,  1913. 

(b)  If  the  fair  market  value  as  at  March  1,  1913,  is 
less  than  cost,  the  loss  which  is  deductible  is  the  excess  of 
such  fair  market  value  over  the  sale  price. 

3.  (a)  No  gain  is  recognized  in  the  case  of  property 
sold  or  exchanged  for  more  than  cost  but  for  less  than 
its  fair  market  value  as  at  March  1,  1913,  and  no  loss  is 
recognized  in  the  case  of  property  sold  or  exchanged  for 
less  than  cost  but  for  more  than  its  fair  market  value  as 
at  March  1,  1913. 

(b)  No  loss  is  recognized  where  property  is  sold  for 
more  than  cost  but  at  less  than  its  fair  market  value  as 
at  March  1,  1913. 

(c)  No  gain  is  recognized  where  property  is  sold  or 
exchanged  for  less  than  cost  but  for  more  than  its  fair 
market  value  as  at  March  1,  1913. 


78  INVESTED  CAPITAL  ACCOUNTING 

Illustrations 

A  purchased  100  shares  of  stock  from  the  Y  Manu- 
facturing Company  in  1912  for  $15  a  share.  The  fair  mar- 
ket value  of  this  stock  was  $20  a  share  on  March  1,  1913. 
In  1920  he  sold  the  100  shares  for  $25  a  share.  What  was 
his  profit  from  this  sale? 

Answer:  A's  profit  from  the  sale  was  $500. 

B  speculated  and  purchased  10  acres  of  land  in  1911 
for  $100  an  acre.  In  the  early  part  of  1913  it  appeared 
that  a  tannery  would  be  established  on  land  adjacent  to 
his  property,  and  land  which  was  adjacent  to  his  property, 
and  also  adjacent  to  the  land  on  which  it  was  proposed  to 
build  the  tannery  was  sold  for  $175  an  acre.  In  1920  B  sold 
his  land  for  $150  an  acre.  How  does  the  sale  of  B's  land 
affect  his  income  tax  liability  for  1920? 

Answer:  It  does  not  affect  his  income  tax  liability 
for  1920,  because  no  loss  or  gain  is  recognized  in  this 
transaction. 

C  purchased  100  shares  of  stock  from  the  M  Railroad 
Company  on  January  5,  1913,  for  $30  a  share.  This  stock 
sold  on  the  New  York  Stock  Exchange  for  $20  a  share  on 
March  1,  1913.  In  1920  C  sold  his  stock  for  $18  a  share. 
What  entry  should  be  made  in  C's  return  for  1920  ? 

Answer :  Loss  of  $200. 

D  purchased  an  apartment  house  in  1909  for  $100,000. 
An  appraisal  of  the  property  was  made  in  February,  1913, 
and  it  was  determined  that  its  value  at  that  date  was 
$75,000.  In  1920  he  sold  the  apartment  house  for  $80,000. 
How  does  the  sale  affect  D's  income  tax  liability  for  1920? 

Answer:  It  does  not  affect  his  income  tax  liability 
for  1920  because  no  loss  or  gain  is  recognized  in  this  trans- 
action. 


CHAPTER  SIX 
PERSONAL  SERVICE  CORPORATIONS 

What  is  a  Personal  Service  Corporation? 

By  "personal  service  corporation"  is  meant  one  in 
which  the  income  is  attributable  to  the  activities  of  the 
share  or  stockholders;  that  is,  they  not  only  render  per- 
sonal service  but  they  actually  perform  to  a  large  extent, 
that  service.  Such  service  is  not  necessarily  of  a  profes- 
sional nature,  but  is  one  in  which  capital  (whether  bor- 
rowed or  invested)  is  not  materially  an  income  produc- 
ing factor. 

Personal  service  corporations  are  not  subject  to  tax 
as  corporations,  unless  they  make  returns  on  a  fiscal  year 
basis  beginning  in  1917,  on  Forms  1031  and  1103.  An 
individual  stockholder  of  a  personal  service  corporation  is 
subject  to  tax  under  the  1918  law  (in  much  the  same  man- 
ner as  a  member  of  a  partnership)  upon  his  share  of  the 
earnings  of  the  corporation,  whether  or  not  the  earnings 
have  been  distributed. 

Every  personal  service  corporation  must  make  a  return 
of  income  regardless  of  the  amount  of  its  net  income.  The 
return  shall  be  on  Form  1065  (revised)  for  1918  and  sub- 
sequent years. 

The  net  income  of  a  personal  service  corporation  is 
computed  on  the  same  basis  as  the  net  income  of  an  indi- 
vidual except  that  no  deduction  is  allowed  for  contributions. 
Thus,  if  a  personal  service  corporation's  books  show  a  net 
increase  of  $8,000  and  a  donation  of  $1,000  was  made  to 


80  INVESTED  CAPITAL  ACCOUNTING 

the  Red  Cross,  a  stockholder  holding  one-fourth  of  the 
shares  would  have  to  report  in  his  return  an  income 
(whether  realized  or  constructive)  from  this  source  of 
$2,250. 

It  should  be  noted,  however,  that  in  the  event  of  a  per- 
sonal service  corporation  filing  a  return  for  a  fiscal  year  be- 
ginning in  1917  that  the  individual  stockholder  will  pay  the 
tax  at  individual  rates  on  his  distributive  share  of  the  earn- 
ings attributable  to  the  1918  portion  of  the  taxable  period, 
while  the  corporation,  as  such,  will  pay  income  and  excess 
profits  taxes  on  that  portion  of  the  net  taxable  income 
attributable  to  the  portion  of  the  taxable  year  covered  by 
the  period  beginning  the  first  day  of  the  fiscal  period  up 
to  and  including  December  31,  1917,  as  is  illustrated  in 
the  following  problem  in  which  it  is  assumed  that  the 
concern  qualified  as  a  personal  service  corporation. 

Illustration 

The  Smith  Engineering  Corporation,  a  personal  service 
corporation,  was  organized  in  1912,  doing  business  on  a 
fiscal  year  basis  ending  June  30.  Their  invested  capital 
for  the  taxable  period  was  nominal.  The  owners  consisted 
of  A,  B,  and  C  who  held  stock  3/5,  3/10  and  1/10  respec- 
tively. The  net  income  reported  was  $30,000. 

Solution 

1917  Law 

Net  income  for  fiscal  year  ended  June  30,  1918 $30,000.00 

Less :    Exemption    3,000.00 


Amount  of  taxable  income $27,000 


Excess  profits  tax  (8%  of  $27,000) $2,160 


INVESTED  CAPITAL  ACCOUNTING  81 

Total  net  income $30,000 

Less :   Excess  profits  tax 2,160 

Income  tax;  2%  and  4%=6%  of $27,840 =$1,670.40 

Plus  excess  profits  tax 2,160.00 


Total  tax  on  basis  of  one  year $3,830.40 


Tax  for  6  months  period  ended  December  30, 
1917  (one-half)    $1,915.20 


Thus,  it  will  be  seen  that  the  corporation  as  such  should 
pay  a  tax  of  $1,915.20  for  the  1917  portion  of  the  period 
and  for  the  1918  portion  the  tax  will  be  paid  by  the  stock- 
holders, based  upon  their  distributive  shares,  as  follows : 

1918  Law 

As  before  stated,  the  individual  owners  of  a  personal 
service  corporation  are  subject  to  tax  much  like  the  mem- 
bers of  a  partnership  upon  their  distributive  shares  of  the 
net  income  of  the  corporation. 

A  should  pay  a  tax  as  an  individual  for  the  1918  por- 
tion, being  one-half  of  the  fiscal  year,  on  his  share  of  the 
net  income,  or  $9,000  plus  any  other  taxable  income  he  may 
have  received. 

B,  in  the  same  manner  as  A,  should  pay  a  tax  on  his 
share  amounting  to  $4,500,  plus  any  other  taxable  income. 

C  should  pay  a  tax  on  his  share,  $1,500,  plus  any  other 
taxable  income. 

Any  amount  paid  on  account  of  the  tax  imposed  under 
the  Revenue  Acts  of  1916  or  1917  shall  be  credited  towards 
the  payment  of  the  tax  of  the  corporation  under  the  portion 
applicable  under  the  1917  law,  and  if  the  amount  so  paid 
exceeds  the  amount  of  tax  assessable,  it  shall  be  refunded 
in  accordance  with  provisions  of  Section  252,  Revenue  Act 
of  1918. 


82  INVESTED  CAPITAL  ACCOUNTING 

The  Difference  Illustrated 

Distinction  between  personal  service  and  non-personal 
service  will  be  illustrated  in  the  case  of  two  incorporated 
business  schools — the  Jonesville  Business  College  and  the 
Hadley  Business  Institute.  The  stock  of  the  Jonesville 
Business  College  is  owned  by  four  persons.  One  of  them 
is  a  hardware  merchant  devoting  most  of  his  time  to  that 
business,  another  is  a  street  car  conductor;  the  third  is 
a  retired  capitalist.  The  fourth  is  an  educator  who  devotes 
all  of  his  time  to  the  activities  of  the  school.  He  owns 
one-fourth  of  the  capital  stock  of  the  corporation  and 
receives  from  the  corporation  a  fair  salary  for  performing 
his  duties,  among  which  is  that  of  instructing  advanced 
classes  in  bookkeeping.  He  has  a  corps  of  instructors  under 
him  and  all  are  on  a  salary  basis.  The  equipment  is  fairly 
large  and  is  reasonably  worth  (net)  $10,000 ;  that  is,  there 
is  capital  invested  in  the  business  to  that  amount. 

The  studentry  is,  of  course,  receiving  personal  service. 
The  books  and  supplies  are  furnished  to  the  students  at 
cost.  The  principal,  who  is  a  stockholder,  is  rendering 
personal  service  as  are  all  of  the  others  of  the  faculty.  Is 
this  an  invested  capital  corporation  or  is  it  a  personal  service 
corporation?  It  is  not  a  personal  service  corporation,  but 
is  an  invested  capital  or  non-personal  service  corporation. 
What  is  the  governing  factor  in  this  instance?  It  is  not 
the  fact  that  $10,000  are  invested  in  the  enterprise.  It 
is  not  solely  because  other  teachers  are  employed.  The 
main  reason  is  that  the  principal  stockholders  do  not  render 
their  personal  services;  the  profits  are  not  primarily  the 
result  of  the  activities  of  the  owners. 

If  each  of  the  three  non-active  stockholders  devoted 
his  time  to  the  work  of  the  school  (one  might  be  a  solicitor 
of  students,  another  might  act  as  janitor,  the  third  as 
teacher,  or  in  some  other  capacity)  then  we  should  be  in- 
clined to  place  it  in  the  personal  service  class.  However, 


INVESTED  CAPITAL  ACCOUNTING  83 

this  is  not  to  be  regarded  as  a  conclusive  test,  as  other 
factors  may  enter  the  equation  that  counteract  this  effect. 

The  Hadley  Business  Institute  is  a  well-equipped 
school.  The  school  occupies  both  floors  of  a  two-story 
building  worth  $30,000  and  owned  by  the  corporation.  The 
equipment,  while  somewhat  run  down,  is  worth  $20,000. 
Ninety-five  per  cent  of  the  stock  is  owned  by  A,  B,  C,  and 
D;  the  other  5%  is  owned  by  outsiders.  Mr.  A  is  a  noted 
specialist  in  commercial  arithmetic.  Mr.  B  is  a  high  grade 
stenographic  instructor.  Mr.  C  is  a  teacher  of  bookkeeping 
and  Miss  D  is  an  expert  teacher  of  typewriting.  These 
persons  are  in  charge  of  the  Departments  in  which  they 
excel  and  each  has  one  assistant.  They  also  employ  a 
solicitor  of  students.  Also  they  have  a  small  English  De- 
partment, conducted  by  a  hired  teacher.  Books  and  sup- 
plies are  supplied  to  the  students  at  cost. 

Is  the  Hadley  Business  Institute  a  personal  service 
corporation?  It  is.  The  profits  of  this  school  are  attribu- 
table to  the  activities  and  reputations  of  the  four  main  or 
principal  stockholders.  The  fact  that  $50,000  is  invested 
is  only  incidental — irrelevant.  The  school  could  be  con- 
ducted with  little  or  no  capital.  The  fact  that  the  cor- 
poration owns  the  building  is  of  no  moment.  A  building 
could  be  rented — so  could  typewriters,  etc.  The  incoming 
tuition  would  take  care  of  current  expenses. 

Change  of  Ownership 

The  statement  that  if  these  persons  were  to  sell  the 
school  to  men  of  lesser  reputation  the  prestige  of  the  school 
would  be  materially  lowered  is  not  open  to  question.  There- 
fore, the  income  is  due,  in  great  measure,  to  the  activities 
and  public  estimate  of  the  principal  stockholders. 

However,  a  change  in  ownership  would  not  necessarily 
take  a  concern  out  of  the  personal  service  class.  If  the  new 


84  INVESTED  CAPITAL  ACCOUNTING 

owners  merely  stepped  into  the  shoes  of  the  former  owners 
and  if  operations  went  on  about  as  before,  the  sale  of  the 
school  would  not  affect  its  status.  But  if  the  new  owners 
bought  it  as  an  investment,  did  nothing  but  merely  super- 
vise its  activities,  and  even  went  so  far  as  to  employ  as 
instructors  the  former  owners,  we  should  class  the  concern 
as  a  non-personal  service  or  capitalistic  corporation. 

Frequency  in  change  of  ownership  during  a  year  should 
not  affect  the  status,  provided  the  conduct  of  the  school 
remained  practically  the  same  as  it  was  formerly. 

Doing  Part  Personal  Service 

Now  let  us  go  a  step  further  with  the  Hadley  concern. 
We  will  assume  that  in  addition  to  the  facts  given  above, 
Mr.  A  wrote  a  text  book  on  commercial  arithmetic  and  that 
the  school  is  publishing  and  selling  it  to  other  schools  or 
to  individuals,  or  that  the  building  in  which  the  school 
is  located,  and  which  the  corporation  owns,  is  an  office 
building  and  a  part  of  it  is  rented  for  office  (or  other) 
purposes.  Or,  we  will  assume  that  a  boarding  school  is 
conducted  and  dormitories  are  rented  to  the  students.  It 
is  manifest  that  now  capital  is  no  longer  a  mere  incident 
to  this  business  but  has  become  a  necessary  factor  in  the 
production  of  income. 

This  phase  of  the  matter  has  changed  the  status  of 
the  Hadley  Business  Institute  from  a  personal  service  cor- 
poration to  that  of  a  corporation  doing  a  part  personal 
service  business,  and  its  tax  must  be  computed  upon  a 
basis  different  from  the  computation  of  the  tax  of  a  per- 
sonal service  corporation  or  from  that  of  a  straight  invested 
capital  (or  non-personal  service)  proposition,  as  will  be 
explained  later.  Any  corporation  carrying  on  two  or  more 
lines  of  business,  one  or  more  of  which  requires  the  use 
of  capital  and  one  or  more  in  which  the  employment  of 
capital  is  not  a  necessity,  must  be  classed  as  a  non-personal 


INVESTED  CAPITAL  ACCOUNTING  85 

service  corporation  unless  the  total  net  income  ascribable  to 
the  personal  service  branch  or  branches  is  equal  to  at  least 
thirty  per  centum  of  the  total  net  income  of  the  corporation, 
in  which  case  the  tax  of  such  net  income  shall  be  separately 
computed,  as  will  be  illustrated  later. 

No  foreign  corporation  may  be  classed  as  a  personal 
service  corporation;  neither  may  a  corporation  50%  or 
more  of  whose  total  gross  income  consists  of  gains,  profits, 
or  income  derived  from  trading  as  a  principal;  nor  may 
any  corporation,  50%  or  more  of  whose  gross  income  con- 
sists of  gains,  profits  or  commissions,  or  other  income  de- 
rived from  a  government  contract  entered  into  between 
April  6,  1917,  and  November  11,  1918,  inclusive. 

Tax  Computations 

The  Jenner  Sanitarium  Company  is  owned  and  con- 
ducted by  five  noted  physicians  and  surgeons.  The  only 
income  is  the  fees  paid  by  patients.  The  operating  appa- 
ratus is  owned  by  the  corporation  as  is  also  the  building  it 
occupies,  which  is  devoted  wholly  to  the  activities  of  the 
business.  The  only  item  the  corporation  sells  is  profes- 
sional services.  In  1918  the  net  income  was  $30,000.  At 
December  31,  1918,  a  dividend  of  $20,000  was  declared  pay- 
able immediately.  What  is  the  corporation's  tax  liability 
for  1918?  None,  as  a  corporation,  but  the  distributed  or 
distributable  share  of  each  stockholder  is  taxable  to  the 
individual  at  the  individual  income  tax  rates. 

Note  that  not  only  is  the  amount  that  was  actually 
distributed  to  stockholders  taxable,  but  also  the  amount 
that  could  have  been  distributed.  This  is  a  good  example 
of  the  application  of  "constructive  receipt."  In  this  instance 
each  stockholder  (as  an  individual)  would  be  required  to 
pay  a  tax  on  $6,000  in  addition  to  the  tax  on  any  other 
income  he  might  have. 


86  INVESTED  CAPITAL  ACCOUNTING 

If  a  portion  (or  all)  of  the  year's  earnings  had  been 
invested  in  additional  facilities  and  little  or  nothing  was 
received  by  the  stockholders,  the  tax  liability  of  the  stock- 
holders would  not  be  lessened.  What  the  Unit  desires  to 
know,  primarily,  is — "How  much  were  the  earnings  for 
the  taxable  period?"  What  the  taxpayer  may  have  done 
with  the  earnings,  either  personally,  or  indirectly  through 
the  medium  of  the  corporation's  directors,  is  usually  of 
interest  only  to  the  stockholders. 

While  personal  service  corporations  pay  a  tax  indi- 
rectly through  the  individual  stockholders  and  the  tax  is 
assessed  against  the  stockholders  as  individuals,  the  cor- 
poration must  file  a  return  and  no  deductions  may  be  taken 
for  donations  made  by  the  corporation.  Thus  if  the  book 
net  income  of  the  Jenner  Company  was  $45,000  and  it  had 
made  a  donation  of  $5,000  to  the  Red  Cross,  each  of  the 
stockholder's  taxable  income  would  amount  to  $10,000  in 
addition  to  any  other  taxable  net  income  they  might  have, 
and  none  of  the  stockholders  could  deduct  his  proportion 
of  the  $5,000  donation,  although  he  could  deduct  (within 
statutory  limitations)  donations  made  by  himself  as  an 
individual. 

If,  during  1918,  this  corporation  made  a  distribution 
of  earnings  accumulated  subsequent  to  February  28,  1913, 
and  prior  to  January  1, 1918,  for  the  purposes  of  the  normal 
tax  (but  not  of  the  surtax)  the  recipients  of  the  dividend 
may  deduct  as  a  credit  whatever  portion  of  such  dividend 
was  received.  The  reason  for  allowing  this  credit  is  that 
the  income  tax  was  paid  (doubtless)  in  the  year  for  which 
it  was  earned. 

Illustrating  Part  Personal  Service 

The  Legal  Advice  Corporation  is  composed  of  several 
attorneys  all  of  whom  are  very  active  in  conducting  the 
business,  the  principal  part  of  which  is  the  giving  of  coun- 


INVESTED  CAPITAL  ACCOUNTING  87 

sel  and  defending  clients  in  litigation.  Occasionally  the 
corporation  purchases  a  piece  of  real  estate  with  the  idea 
of  later  selling  it  at  a  profit. 

In  1918  the  total  gross  income  of  the  corporation  was 
$100,000  of  which  $75,000  is  attributable  purely  to  pro- 
fessional services  and  $25,000  to  real  estate  operations. 
The  net  profit  ascribable  to  professional  services  was  $50,- 
000  and  the  amount  realized  from  real  estate  deals  was 
$10,000.  This  is  a  corporation  doing  a  business  that  is 
part  personal  service  and  taxable  as  such.  Had  the  gross 
income  from  trading  been  50%  or  more  of  the  total  gross 
income,  or  had  the  net  income  from  professional  services 
been  less  than  30%  of  the  total  net  income,  we  should  have 
to  tax  this  corporation  at  non-personal  service  corporation 
rates;  in  other  words,  the  personal  service  element  would 
be  ignored. 

The  following  illustration  shows  how  the  tax  is  com- 
puted with  the  respect  of  a  corporation  doing  part  personal 
service. 

It  is  ascertained  that  the  pre-war  invested  capital 
averaged  $30,000  of  which  $20,000  was  employed  in  real 
estate  deals.  The  pre-war  net  income  averaged  $45,000, 
of  which  $15,000  is  attributable  to  real  estate  activities. 

We  first  compute  the  tax  on  that  part  of  the  business 
that  is  deemed  non-personal  service. 

The  specific  exemption  granted  corporations  is  $3,000. 
We  allow  in  the  case  of  a  corporation  doing  part  personal 
service,  the  proportion  of  this  amount  that  bears  the  same 
relation  to  $3,000  as  does  the  real  estate  (non-personal 
service)  net  income  to  the  total  net  income,  or  $500.  To 
this  we  will  add  8%  of  the  invested  capital  employed  in 
the  real  estate  business  (say  $40,000  attributable  to  real 
estate  and  $20,000  to  personal  service)  or  $3,200,  a  total 


88  INVESTED  CAPITAL  ACCOUNTING 

exemption  of  $3,700.  The  war  profits  credit  is  a  specific 
exemption  of  $500  (that  is  one-sixth  of  $3,000)  plus  the 
pre-war  average  net  income,  $15,000,  plus  10%  of  the  in- 
crease in  invested  capital  for  1918  over  that  of  the  pre- 
war period  ($2,000),  or  a  total  war  profits  credit  of  $17,500. 


Schedule  III — Excess  and  War  Profits  Credit 

8%   of   invested  capital $3,200 

Exemption    500 

Excess  profits  credit $3,700 


Average  net  income  for  the  pre-war  period $15,000 

Plus  10%  increase  in  invested  capital 2,000 

Plus  exemption 500 

War  profits  credit $17,500 

Schedule  IV— Brackets  I  and  II 

Not  over  20%  of  invested  capital  $8,000  minus  excess  profits 

credit=$4,300  by  30%  = $1,290 

Over  20%  of  invested  capital  (10,000  minus  $8,000 =$2,000) 

by  65%  = 1,300 

Excess  profits  tax $2,590 

Bracket  III 

Net  income  for  taxable  year $10,000 

Less  war  profits  credit 17,500 


(No  war  profits  tax) 

The  above  gives  a  tax  of  $2,590,  on  a  taxable  income 
amounting  to  $10,000  or  a  rate  of  .2590.  This  is  the  rate 
to  apply  to  that  portion  of  the  income  attributable  to  per- 
sonal service. 

$50,000  x  .2590=$12,950. 


INVESTED  CAPITAL  ACCOUNTING  89 

To  this  amount  must  be  added  the  $2,590  tax  found 
under  Schedule  III  making  a  total  war  and  excess  profits 
tax  of  $15,540. 

Were  the  percentage  obtained  above  less  than  20%, 
the  tax  would  be  computed  on  the  entire  net  income  with- 
out regard  to  the  personal  element  phase  of  the  case.  In 
such  event  we  should,  of  course,  allow  not  only  the  capital 
invested  in  the  non-personal  service  part,  but  also  the 
capital  employed  in  the  personal  service  branch  of  the  busi- 
ness. Also,  we  should  allow  the  entire  exemption  of  $3,000. 
In  other  words,  it  should  be  treated  strictly  as  a  capitalistic 
corporation. 

The  author  believes  this  to  be  the  correct  interpreta- 
tion of  Section  303,  and  some  very  able  auditors  agree  with 
him,  while  others  take  different  views.  The  following  is 
a  view  expressed  by  a  member  of  the  Technical  Staff,  whose 
view  coincides  with  the  view  of  the  author: 


"Section  303  apparently  should  be  recognized  only  as  a 
relief  section.  In  such  event  it  would  not  apply  generally  in 
the  application  of  tax  determination.  Therefore,  considering 
it  in  the  form  of  furnishing  relief  for  a  taxpayer,  it  will  be 
his  privilege  to  take  advantage  of  the  section  but  only  in  so 
far  as  he  is  willing  to  comply  with  its  provisions,  because  in 
any  event  the  taxpayer  desires  to  seek  relief  for  the  reason 
that  he  believes  he  is  taxed  under  severe  circumstances  owing 
to  the  peculiar  nature  of  his  business  that  comes  under  the 
section  which,  of  course,  would  cause  the  tax  to  be  dispro- 
portionate. 

"Knowing  the  above,  it  should  be  the  duty  of  the  taxpayer 
to  comply  with  the  law  (section  303)  as  it  is,  and  if  he  can- 
not do  so  the  section  would  not  afford  relief  which  relief 
should  then  be  sought  elsewhere. 

"In  order,  therefore,  for  a  taxpayer  to  qualify  for  the  re- 
lief intended  it  becomes  necessary  that  certain  arbitrary  rules 
be  met  which  in  this  case  are  specifically  stated  in  the  statute. 


90  INVESTED  CAPITAL  ACCOUNTING 

If  the  taxpayer  cannot  comply  or  meet  the  qualification  as 
set  forth  then  it  becomes  evident  that  the  section  is  not  in- 
tended for  his  benefit. 

"If  the  taxpayer  qualifies  and  the  section  is  applied  then 
the  computation  must  sustain  his  contention  in  that  the  tax 
from  a  capitalistic  source  is  20%  or  over  and  in  that  way 
establish  his  rate  for  the  Personal  Service  classification  por- 
tion. It  is  safe  to  assume  that  the  section  intends  to  fix  a 
line  somewhere  in  order  that  the  advantages  of  this  relief 
section  would  not  be  abused. 

"Now  then,  if  the  corporation  cannot  meet  the  arbitrary 
stipulations  of  the  statute,  although  the  corporation  is  partly 
capitalistic  and  partly  Personal  Service  class,  the  remedy 
that  will  afford  relief  would  be  Sections  327  and  328. 

"I  believe  that  this  section  was  purposely  made  restrictive 
in  order  to  avoid  abuse  of  same  and  really  to  furnish  a  form 
of  relief  for  the  difficult  cases  of  capitalistic  and  Personal 
Service  nature." 


The  following  is  an  opposing  view  written  by  another 
member  of  the  Technical  Staff : 


"It  is  stated  in  the  text  that  'were  the  percentage  obtained 
above  (the  percentage  of  tax  to  the  capitalistic  income  of  the 
business)  less  than  20%  the  tax  would  be  computed  on  the 
entire  net  income  without  regard  to  the  personal  service 
element .' 

"This  would  be  denying  the  corporation  the  relief  that  it 
was  intended  Section  303  should  give  to  a  corporation  doing 
part-personal  service  business. 

"It  is  only  in  the  event  of  the  tax  upon  the  whole  income 
computed  under  section  301,  being  less  than  20%  that  a  cor- 
poration applying  for  taxation  under  section  303,  shall  be 
denied  relief  under  the  section. 

"If  the  tax  computed  on  the  income  from  the  first  part 
(capitalistic)  is  less  than  20%,  and  the  tax  on  the  whole  in- 


INVESTED  CAPITAL  ACCOUNTING  91 

come  (computed  under  section  301)  is  more  than  20%  then 
20%  should  be  applied  to  the  second  part.  In  other  words, 
it  seems  reasonable  to  suppose  that  if  the  provisions  of  the 
statute  state  that  in  no  case  less  than  20%  shall  be  charged 
20%  must  be  charged  if  the  computation  results  in  a  smaller 
percentage. 

"The  only  condition  (as  regards  percentage  of  tax)  as 
stated  above,  upon  which  a  corporation,  applying  for  303, 
is  thrown  back  into  301,  is  where  the  tax  on  the  whole  income 
(under  301)  is  less  than  20%." 


Which  View? 

Which  view  is  the  auditor  to  accept?  The  author  is 
very  sure  that  the  first  view  is  correct,  but  he  does  not 
know  that  it  is  right.  Those  who  take  the  opposing  view 
also  feel  sure  of  their  ground,  but  they  admit  as  willingly 
as  does  the  author  that  they  do  not  know  that  they  are 
right  in  their  view. 

This  matter  is  being  presented  to  the  solicitor  for  an 
opinion  and  the  only  thing  for  you  to  do  is  to  watch  the 
Bulletins  and  when  the  opinion  appears,  erase  such  portions 
of  this  text  as  are  contrary  to  the  opinion  given. 

A  Wrong  Assumption 

At  first  glance  it  may  be  thought  that  to  arrive  at 
a  percentage  as  is  done  in  the  preceding  problem  and  then 
to  apply  that  percentage  to  the  personal  service  portion 
would  be  failing  to  give  the  corporation  doing  part-personal 
service  any  advantage,  in  that  the  entire  income — both 
non-personal  service  and  personal  service  contributes  tax 
at  the  same  rate.  The  fallacy  of  this  assumption  will  be 
clear  by  computing  the  tax  on  the  basis  that  this  is  a  non- 
personal  service  corporation. 

Note  the  difference  in  the  amount  of  tax  resulting. 


92  INVESTED  CAPITAL  ACCOUNTING 

Schedule  III 

8%  of  invested  capital $4,800 

Exemption    3,000 


Excess  profits  credit $7,800 

Average  income  for  the  pre-war  period $45,000 

Plus  10%  increase  in  invested  capital 3,000 

Plus  exemption 3,000 

$51,000 


Schedule  IV 

Not  over  20%  of  ($12,000— $7,800 -$4,200)  by  30%=  $1,260 
Over  20%  of  ($60,000— $12,000 =$48,000)  by  65%  =  ..  31,200 

Excess  profits  tax $32,460 

Net  income  for  taxable  year $60,000 

Less  war  profits  credit 51,000 


(No  war  profits  tax) $9,000x80% =$7,200 

You  will  note  that  the  excess  profits  tax  has  jumped 
from  $15,540  to  $32,460  by  reason  of  computing  it  on  the 
non-personal  service  basis.  To  the  profits  tax  must  (as  de- 
termined on  page  9)  be  added  the  income  tax,  in  the  fol- 
lowing manner : 


Total  profits  tax .$15,540.00 

Net  income  for  taxable  year $60,000 

Less:    War   and    excess    profits 

tax  $15,540 

Exemption   2,000       17,540 

Balance  subject  to  income  tax $42,460x12%  =  5,095.20 


Total  tax  assessable $20,635.20 


INVESTED  CAPITAL  ACCOUNTING  93 

In  determining  as  to  whether  or  not  a  corporation  is 
personal  service  or  non-personal  service,  no  fixed  rules  can 
be  laid  down  that  would  apply  to  the  general  run  of  cases 
but,  usually,  unless  at  least  80%  of  the  outstanding  stock 
is  owned  by  those  who  actively  conduct  the  business  and 
whose  personal  efforts  bring  in  most  of  the  income,  it  must 
not  be  classed  as  a  personal  service  corporation.  However, 
the  80%  limit  is  not  a  conclusive  factor;  there  are  instances 
where  personal  service  has  been  established  on  a  lower 
basis.  Note  that  Article  1529  makes  the  80%  limit  only 
with  reference  to  filing  returns  "in  the  first  instance."  It 
is  conceivable  that  a  return  "in  the  first  instance"  would 
be  filed  on  a  strict  capitalistic  basis  and  a  claim  then  en- 
tered by  the  taxpayer  for  assessment  under  Section  303 
which  might  be  allowed. 

Amount  of  Capital 

To  be  classed  as  a  non-personal  service  corporation,  it 
is  not  necessary  that  the  invested  capital  be  even  reason- 
ably large.  You  will  note  that  the  Regulations  do  not 
require  that  there  be  any  invested  capital — but  they  do 
require  that  all  corporations  be  classed  as  non-personal 
service  if  capital  (note  "capital,"  not  "invested  capital") 
is  a  material  income-producing  factor.  Thus  a  concern  may 
buy  and  sell  coal  in  large  quantities.  The  reputation  and 
standing  of  the  stockholders  may  be  such  that  credit  is 
granted  in  large  amounts.  It  may  never  handle  or  see  the 
coal.  It  may  take  the  order  of  the  customer  and  place 
the  order  with  the  mine  and  the  coal  is  shipped  direct  to 
its  customer  and  it  may  pay  for  it  when  the  customer  pays. 
It  may  need  only  enough  invested  capital  to  purchase  a 
desk,  install  a  'phone  and  pay  a  month's  rent  (all  of  this 
could,  conceivably,  be  done  on  credit).  Nevertheless,  it 
is  not  a  personal  service  corporation.  But,  if  it  simply 
acted  as  agent  for  the  coal;  if  the  coal  were  billed  by  the 
mine  to  the  customer ;  and  if  the  corporation  is  not  respon- 


94  INVESTED  CAPITAL  ACCOUNTING 

sible  for  the  payment  of  the  coal,  it  would  become  a  personal 
service  corporation  even  though  it  had  invested  consider- 
able money  in  luxurious  office  fixtures,  etc. 

The  first  instance  cited  just  above  is  a  parallel  of  thou- 
sands of  cases  of  people  doing  business  where  capital  is 
necessary.  The  fact  that  a  concern  such  as  this  (and  it  is 
not  far  fetched — the  writer  audited  a  very  similar  case) 
can  do  business  without  capital,  is  only  incidental.  It  is 
a  class  of  business  in  which  capital  is  almost  without  excep- 
tion necessary,  and  in  deciding  whether  any  case  is  personal 
service  or  non-personal  service,  if  it  is  determined  that  the 
business  is  such  as  to  require  capital  in  its  conduct,  then 
it  may  not  be  classed  as  a  personal  service  corporation. 

A  Further  Illustration 

Let  us  cite  another  hypothetical  case.  We  will  take 
the  matter  of  the  Clipper  Barbering  Corporation.  It  is 
composed  of  three  stockholders — each  owning  one-third  of 
the  stock  authorized. 

The  corporation  has  a  very  small  amount  invested, 
having  been  able  to  acquire  the  use  of  a  large,  well  equipped 
shop  at  a  fair  rental.  Being  well  and  centrally  located,  a 
very  large  business  is  done.  There  are,  in  addition  to  the 
three  stockholders  (who  are  practicing  barbers)  twelve 
other  barbers,  two  shiners  and  two  porters.  A  return  was 
duly  filed  and  a  claim  was  entered  to  the  effect  that  the 
concern  should  be  classed  as  a  personal  service  corporation. 
Should  this  claim  be  allowed?  No.  The  guiding  rea- 
sons are: 

(a)  Such  business,  of  this  apparent  magnitude,  ordi- 
narily requires  capital.  In  this  case,  rented  capital 
is  in  use  and  if  this  rented  capital  were  not  em- 
ployed, other  capital  would  have  to  be  employed. 
It  is  evident  that  in  this  case  capital  is  a  large 


INVESTED  CAPITAL  ACCOUNTING  95 

factor  in  the  production  of  income.  However,  the 
mere  fact  that  a  very  large  volume  of  business  is 
done  is  not,  of  itself,  a  determining  factor. 

(b)  That  the  stockholders  do  barbering  is,  in  this  in- 
stance, only  incidental.    The  bulk  of  the  income  is 
the  result  of  the  labor  of  hired  employees. 

(c)  That  the  stockholders  may   actively   direct  the 
business  at  all  times  and  in  all  ways  has  no  bear- 
ing in  this  case,  and,  in  fact  is  a  determining  ele- 
ment in  very  few,  if  in  any  cases. 

Income  from  Royalties 

The  writer  of  this  book  was  conferee  in  a  conference 
with  a  taxpayer's  representative  in  which  the  representa- 
tive of  the  corporation  claimed  that  his  client  should  be 
assessed  as  a  personal  service  corporation  for  the  reason, 
as  he  said,  "It  was  engaged  neither  in  trading  nor  manu- 
facturing,"— that  all  of  the  income  was  derived  from  royal- 
ties on  patents;  that  no  capital  was  needed  to  carry  on 
the  business;  that  all  his  client  had  or  needed  to  carry 
on  the  business  was  a  small  office  and  one  stenographer. 

His  claim  was  not  allowed.  He  overlooked  the  fact 
that  in  order  to  receive  income  from  the  patents  it  was 
necessary  for  his  client  to  own  or  exercise  control  of  the 
patents  and  this  ownership  or  control  involved  the  use  of 
capital,  and  that  the  income  was  the  result  of  the  employ- 
ment of  that  capital.  However,  it  is  conceivable  that  royal- 
ties might  be  received  from  patents  where  there  was  no 
capital  invested. 

Whether  capital  was  actually  invested  by  the  stock- 
holders or  was  borrowed  capital  is  irrelevant.  Therein  lies 
a  marked  difference  between  capital  which  may  be  stock- 
holders' investment  or  it  may  be  borrowed  capital,  and 
invested  capital  which  consists  only  of  capital  which  the 


96  INVESTED  CAPITAL  ACCOUNTING 

stockholders  have  actually  put  into  the  business,  or  of 
accumulated  earnings  which  they  have  permitted  to  remain 
in  the  business  free  and  unallocated  in  any  way,  save  only 
as  true  surplus  may  be  legitimately  allocated  to  certain 
true  reserves. 

Royalties  received  from  copyrights,  etc.,  would  be 
treated  the  same  as  royalties  from  patents. 

A  Peculiar  Situation 

Section  303,  Regulations  45,  stipulates  that  the  tax 
imposed  on  the  portion  of  the  income  derived  from  personal 
service  "shall  be  the  same  percentage  thereof  as  the  tax 
so  computed  upon  the  first  part  is  of  such  first  part:  Pro- 
vided, That  the  tax  upon  such  second  part  shall  in  no  case 
be  less  than  20  per  centum  thereof,  unless  the  tax  upon 
fhe  entire  net  income,  if  computed  without  benefit  of  this 
Section,  would  constitute  less  than  20  per  centum  of  such 
entire  net  income,  in  which  event  the  tax  shall  be  deter- 
mined upon  the  entire  net  income,  without  reference  to 
this  Section,  as  other  taxes  so  determined  under  this 
title  *  *  *  ." 

Let  us  speculate  a  little.  We  will  assume  that  a  certain 
corporation  claims  to  be  doing  part  personal  service  busi- 
ness and  that  its  claim  meets  all  the  tests  required.  We 
will  also  assume  that  the  portion  of  the  business  that  is 
non-personal  service  was  conducted  without  profit — it  just 
"broke  even,"  but  that  there  was  a  profit  derived  from  the 
personal  service  branch  of  the  business.  How  are  we  going 
to  determine  the  percentage  of  tax  to  be  applied  to  this 
latter  branch  ?  We  cannot  get  the  percentage  as  called  for 
in  Section  303,  for  no  percentage  is  possible. 

Tentative  Answer  to  the  Question 

Section  303  tells  us  that  the  tax  must  be  at  least  20 
per  cent  of  the  personal  service  income,  unless  the  tax, 


INVESTED  CAPITAL  ACCOUNTING  97 

if  computed  with  the  benefits  of  Section  303,  would  be  less 
than  20  per  centum.  It  is  evident  that  the  law  is  not 
clear  on  this  point,  but  it  seems  to  some  that  this  provision 
would  help  us  out  and  it  has  been  suggested  that  the  only 
possible  way  of  determining  the  amount  of  tax  is  to  com- 
pute the  tax  without  the  benefit  of  Section  303  but  com- 
pute the  tax  under  Section  301  ignoring  Section  303  alto- 
gether. However,  in  this  procedure  Section  302  would  have 
to  be  borne  in  mind,  and  if  it  should  apply,  the  tax  computed 
must  come  within  the  limitations  therein  stated. 

To  go  farther  into  this  question  let  us  assume  that 
a  loss  was  suffered  in  that  portion  of  the  business  which 
was  non-personal  service.  Shall  we  deduct  the  loss  therein 
incurred  from  the  profit  derived  from  the  personal  service 
branch  of  the  business?  Neither  the  law  nor  the  Regula- 
tions state  definitely  what  to  do. 

But  I  do  not  believe  that  the  procedure  outlined  above 
covers  the  case  properly.  I  do  not  believe  it  is  the  correct 
procedure  notwithstanding  the  fact  that  I  have  heard  some 
able  men  uphold  it.  I  believe  that  the  first  line  of  Section 
303  points  out  the  way.  It  is  an  axiom  that  a  Whole  is 
greater  than  any  of  its  parts,  and  that  a  part  cannot  equal 
a  whole.  Section  303  says  "That  if  part  of  the  net  income 
*  *  *  ."  That  is  the  only  section  authorizing  a  special 
tax  on  incomes  derived  from  personal  service.  All  other 
taxes  on  personal  service  are  assessed  against  the  distribu- 
tive share  of  each  of  the  stockholders.  Now,  if  a  corpor- 
ation doing  a  part  personal  service  business  sustains  a  loss 
in  the  non-personal  branch  or  just  breaks  even  in  that 
branch,  then  ALL  of  their  net  income  is  from  personal 
service  operations  and  Section  303  does  not  apply  in  so  far 
as  tax  computation  is  concerned.  The  only  way  we  have 
left  to  arrive  at  the  tax  of  such  a  concern  is  to  compute 
the  tax  on  the  same  basis  that  we  would  compute  the  tax 
of  a  corporation  doing  nothing  but  personal  service  business. 


CHAPTER  SEVEN 
CAPITAL  STOCK— TREASURY  STOCK 


Caution 


Before  you  begin  the  study  of  this  portion  of  this 
book,  accept  a  word  of  advice,  which  is:  attempt  to  learn 
only  one  thing  at  a  time,  and  the  particular  thing  for  you 
to  learn  now  is  the  matter  treated  of  in  this  chapter.  Leave 
subsequent  chapters  alone  until  you  know  this  one.  Yes, 
one  word  further — do  not  speculate  on  hypothetic  proposi- 
tions; the  subject  of  tax  law  is  so  full  of  stern,  practical 
problems  that  you  will  be  kept  wholly  occupied  without 
entering  into  the  realm  of  the  visionary. 

Before  beginning  the  study  of  this  chapter,  it  is  advis- 
able that  you  make  a  thorough  study  of  Article  831,  Regu- 
lations 45. 

Capital  Stock 

In  determining  the  invested  capital  of  a  corporation, 
our  whole  effort  is  to  ascertain  the  amount  of  money  the 
stockholders  have  invested  in  the  corporation,  and  as  the 
first  step  toward  the  accomplishment  of  this  object,  capital 
stock  must  be  considered.  There  are  various  classes  of 
stock,  such  as  common  stock,  preferred  stock,  no-par  value 
stock,  or  some  modification  of  these  terms,  but  by  what 
title  the  stock  may  be  labeled  we  care  little;  the  question 
we  want  answered  is:  What  did  the  corporation  realize  in 
dollar- value  when  it  issued  the  stock? 

We  are  not  primarily  interested  in  the  amount  of 


INVESTED  CAPITAL  ACCOUNTING  99 

capital  stock  authorized;  it  is  the  amount  issued  that  is 
a  more  important  factor.  The  mere  fact  that  a  given 
amount  of  stock  is  authorized  does  not  indicate  that  it  has 
been  issued,  and  the  fact  that  it  has  been  issued  does  not 
necessarily  imply  that  it  is  now  outstanding — in  the  hands 
of  stockholders — some  of  it,  having  been  fully  paid  for, 
may  have  been  returned  to  the  treasury  of  the  corporation, 
either  by  donation  or  through  the  giving  by  the  corpor- 
ation of  some  asset  in  exchange  for  the  stock,  thereby 
creating  treasury  stock. 

Again,  all  of  it  may  have  been  issued  but  not  issued 
at  par  value.  It  is  true  that  most  states  require  that  cap- 
ital stock  be  issued  at  a  price  at  least  equal  to  par,  but 
this  is  not  universally  the  case,  and  there  are  various  ways 
of  evading  the  provisions  of  the  law.  Further,  some  states 
— a  constantly  increasing  number — permit  the  issuance  of 
stock  of  no-par  value. 

In  some  instances  the  stock  of  no-par  value*  may  be 
issued  for  any  price  determined  upon  by  the  directors  of 
the  corporation.  The  price  for  which  it  is  issued  today 
does  not  necessarily  set  the  price  for  which  it  may  be  issued 
tomorrow.  In  some  states,  however,  a  stated  minimum 
value  must  be  received  for  stock  of  no-par  value.  With 
these  niceties  of  distinction  we  have  at  present  no  par- 
ticular concern.  They  do  raise  interesting  questions  in 
general  accounting  practice  but  they  do  not  materially  enter 
into  our  present  subject  for  the  reason  that  we  do  not  care 
what  the  particular  present  value  of  the  stock  is,  nor  the 
name  by  which  the  stock  is  known,  and  with  the  excep- 
tions which  will  be  cited  later,  we  do  not  care  to  know 
how  many  shares  have  been  issued.  What  we  do  care  for, 
however,  is:  How  much  stock  is  actually  outstanding  and 


*The  author  has  in  preparation  a  work  entitled,  "Stock  of  No-Par 
Value;  Its  Economic  and  Accounting  Aspects."  It  is  hoped  to  place  it 
on  the  market  early  in  1923. 


100  INVESTED  CAPITAL  ACCOUNTING 

what  amount  of  value,  expressed  in  dollars,  did  the  cor- 
poration receive  for  the  stock  issued?  When  we  have 
arrived  at  this  figure  we  shall  have  reached  the  first  mile- 
stone on  the  road  to  invested  capital — and  invested  capital 
is  the  money  or  its  equivalent  that  the  stockholders  have 
invested  in  the  enterprise  or  have  allowed  to  remain  in  the 
enterprise  in  the  form  of  surplus. 

Note  particularly  that  I  have  used  the  present  perfect 
tense — "have  invested."  It  might  have  been  invested  in 
the  past  and  a  portion  or  all  of  the  investment  may  have 
been  returned  to  the  investor,  prior  to  the  taxable  year, 
in  which  event  it  would  not  now  be  invested  capital.  Also, 
it  must  have  been  "invested" — present  worth  of  the  hold- 
ings, or  market  quotations  have  absolutely  no  bearing.  The 
only  point  is — How  much  money  (or  its  equivalent)  did 
these  stockholders  take  a  chance  in  losing  by  investing  in 
the  capital  stock  of  the  concern  and  (or)  by  allowing  actual 
net  earnings  to  remain  in  the  surplus  of  the  corporation? 

If  stock  is  issued  to  the  amount  of  $100,000  and  sells 
at  par  value,  the  invested  capital,  so  far  as  the  item  of 
capital  stock  is  a  factor,  is  $100,000.  If  it  sold  for  more 
than  par  value,  say  at  a  premium  of  20%,  then  the  invested 
capital  is  $120,000.  On  the  Balance  Sheet  we  should  find- 
Assets  Liabilities  and.  Capital 

Sundry  Assets $120,000   Capital    Stock $100,000 

Capital  Stock  Premium.     20,000 


$120,000  $120,000 


The  Premium  might  be  set  up  as  some  kind  of  Sur- 
plus, as  is  explained  in  Chapter  Seven. 

Assuming  that  the  corporation  is  one  issuing  stock 
without  par  value;  assuming  further  that  it  is  authorized 


INVESTED  CAPITAL  ACCOUNTING  101 

to  issue  10,000  shares,  and  that  it  has  issued  1,000  shares 
at  $12  a  share  and  that  its  Balance  Sheet  is  substantially 
as  follows : 

Assets  Liabilities  and  Capital 

Cash    $12,000   No-par    value    stock    1,000 

shares  issued  for  $12  per 
share   $12,000 

$12,000  $12,000 


how  do  we  determine  the  amount  of  invested  capital? 

It  is  evident  from  the  above  that  the  stockholders 
have  precisely  the  same  money  invested  in  the  business 
that  they  would  have  had  had  the  corporation  issued  120 
shares  having  a  par  value  of  $100,  at  par.  In  other  words, 
their  invested  capital  is  what  they  have  put  into  the  busi- 
ness—$12,000. 

But  suppose  that  shares  were  issued  at  different 
periods  and  at  different  prices  per  share,  and  suppose  fur- 
ther that  the  concern  also  has  outstanding  common  stock 
of  a  par  value  of  $100.  Assume  this  to  be  the  case  with 
the  corporation  whose  Balance  Sheet  has  just  been  pre- 
sented and  that  1,000  shares  of  no-par  value  stock  were 
issued  for  $12  per  share  and  1,000  shares  were  issued  for 
$15  per  share,  and  we  have  submitted  to  us  something  like 
the  following: 

Assets  Liabilities  and  Capital 

Cash    $50,000   Common  stock,  par  value 

Sundry  Assets 77,000       $100   $100,000 

No-par  value  stock,  10,000 
shares  authorized  2,000 
shares  issued  for 27,000 


$127,000  $127,000 


102  INVESTED  CAPITAL  ACCOUNTING 

The  principle  does  not  change;  the  various  values  for 
which  no-par  value  stock  was  issued  occasion  us  no  trouble ; 
if  some  were  issued  for  one  dollar  a  share  and  some  of 
the  same  stock  were  issued  for  $100  a  share,  the  principle 
remains  the  same — how  much  value  did  all  the  stock 
bring  in? — that's  what  counts — nothing  else  does. 

The  reader  will  now  perceive  that,  in  so  far  as  invested 
capital  is  concerned,  it  matters  not  by  what  term  the  capital 
stock  may  be  known,  the  only  thing  that  counts  is — How 
many  dollars'  value  did  it  bring  to  the  corporation? 

Treasury  Stock 

It  is  the  desire  of  the  writer  to  emphasize  as  strongly 
as  possible  the  fact  that,  so  far  as  invested  capital  account- 
ing is  concerned,  Treasury  Stock  is  not  an  asset.  We  are 
fully  aware  that  some  able  accountants  do  classify  it  as 
an  asset,  but  regardless  of  what  view  you  may  hold  on  the 
question  as  regards  general  accounting  practice,  in  your 
Income  Tax  work  you  must  regard  it  as  being  a  reduction 
of  Capital  Stock  outstanding.  In  other  words,  there  is 
only  one  place  to  put  it  on  the  balance  sheet,  and  that  is 
as  a  reduction  of  capital  stock  issued.  I  contend  that  Treas- 
ury Stock  is  never  an  asset  in  any  phase  of  accounting, 
but  this  is  not  the  place  to  discuss  the  question  from  the 
viewpoint  of  general  accountancy. 

Unissued  Stock  is  not  Treasury  Stock,  notwithstanding 
the  fact  that  some  corporations  so  classify  it.  Treasury 
Stock  can  only  be  stock  that  has  been  issued — outstanding 
— and  returned  to  the  treasury  of  the  corporation.  This 
may  be  brought  about  in  a  number  of  ways. 

Working  capital  might  be  needed  and  the  stockholders 
might  return  a  portion  of  their  holdings  to  the  corporation, 
either  as  a  gift  or  otherwise,  for  resale,  and  the  returned 
stock  would  be  shown  on  the  Balance  Sheet  in  one  of  the 
two  ways  that  follow: 


INVESTED  CAPITAL  ACCOUNTING  103 

Assets  Liabilities  and  Capital 

Cash    $10,000    Notes  Payable $150,000 

Sundry  Assets 440,000   Capital   Stock 300,000 

Treasury  Stock 70,000    Surplus   70,000 


$520,000  $520,000 


For  invested  capital  purposes,  the  above  is  not  a  true 
statement.    The  second  and  better  way  is  as  follows : 


Assets  Liabilities  and  Capital 

Cash    $10,000   Notes  Payable $150,000 

Sundry  Assets 440,000    Capital    Stock. $300,000 

Less  Treasury 

Stock    70,000       230,000 


Surplus   70,000 


$450,000  $450,000 


You  will  now  see  that  Treasury  Stock  must  be  deducted 
from  the  total  amount  of  stock  issued  to  obtain  the  amount 
of  stock  actually  outstanding. 

The  above  is  a  true  statement  for  invested  capital  pur- 
poses, and  the  invested  capital  would  be  the  amount  of 
stock  outstanding  plus  the  Surplus,  or  $300,000,  provided, 
that  when  the  stock  was  originally  issued  the  corporation 
received  in  cash  or  its  unquestionable  equivalent  $300,000 
for  it. 

If  the  stock  were  issued  for  property,  tangible  or  in- 
tangible, and  a  portion  of  the  stock  were  returned  to  the 
corporation  as  a  gift,  or  at  a  price  "substantially  less  than 
its  par  value,"  then  that  portion  of  the  stock  is  treated 


104  INVESTED  CAPITAL  ACCOUNTING 

as  not  having  been  issued  for  property — in  other  words, 
the  property  for  which  all  the  stock  that  was  issued  to  the 
person  who  returns  a  portion  of  it  is  regarded  as  being 
worth  not  more  than  the  par  value  of  the  stock  retained 
by  the  donor,  and  any  Surplus  that  has  been  set  up  as  an 
offset  to  this  fictitiously-valued  property  must  be  elimi- 
nated. Article  861.  In  such  event,  the  true  Balance  Sheet 
would  show — 


Assets  Liabilities  and  Capital 

Cash   $10,000   Notes  Payable $150,000 

Sundry  Assets 370,000    Capital   Stock. $300,000 

Less  Treasury 

Stock 70,000       230,000 


$380,000  $380,000 


Thus  we  see  that  the  actual  invested  capital  under  such 
conditions,  is  reduced  to  $230,000.  This  adjustment,  in 
connection  with  the  reduction  of  Capital  Stock,  is  the  mis- 
named "double  deduction,"  a  term  that  never  should  have 
been  applied,  owing  to  the  fact  that  it  has  caused  some 
to  get  a  wrong  impression.  It  is  not  a  double  deduction 
of  any  one  thing.  There  is  a  reduction  of  Capital  Stock 
and  an  adjustment  of  Surplus  to  its  true  amount. 

Had  this  stock  originally  been  issued  for  cash,  at  its 
par  value,  no  Surplus  adjustment  would  be  required. 

Under  Schedule  E,  line  3,  would  be  entered  the  amount 
of  Capital  Stock  set  up  by  the  corporation.  If  any  of  this 
stock  had  been  issued  at  a  premium,  the  excess  over  the 
par  value  would  be  entered  in  line  5.  If  there  were  any 
Treasury  Stock  carried  as  an  asset,  the  amount  of  same 
should  be  placed  in  line  9. 


INVESTED  CAPITAL  ACCOUNTING  105 

Note  that  line  9  says,  "Deduct  cost  of  Treasury  Stock 
(or  book  value  if  different  from  cost)."  If  it  cost  the 
corporation  nothing1,  that  is,  if  it  was  "returned  as  a  gift, 
or  for  a  consideration  substantially  less  than  its  par  value," 
and  the  corporation  carries  it  as  an  asset  at  par  value,  or 
at  any  other  figure,  deduct  the  book  value;  not  the  cost 
(to  the  corporation)  of  the  stock.  This  takes  care  of  the 
Treasury  Stock  deduction,  but  it  does  not  make  the  necessary 
adjustment  to  Surplus.  Refer  to  Form  1120,  G2  for  1919. 
The  answer  to  both  questions  under  G2  being  "yes,"  in 
this  particular  instance,  we  should  have  a  statement  some- 
thing like  this : 


(a)  Sundry  assets 

(b)  At  organization 

(c)  Par  value  of  stock  (assume  that  donor  was  issued 

stock  amounting  to  $150,000) $150,000 

(d)  Actual  cash  value  of  property  when  paid  in 80,000 

(e)  Cost  less  depreciation 

(f )  Value  entered  on  books 150,000 

(g)  Excess  value 70,000 


Manifestly  this  might  be  an  adjustment  of  Surplus, 
since  Surplus  is  unduly  increased  by  $70,000,  but  the  Form 
does  not  so  provide.  However,  the  correct  result  is  obtained 
by  entering  the  amount  in  line  2,  Schedule  G. 


Valuation  of  Property  Received  for  Stock 

It  is  generally  conceded  that  one  of  the  prerogatives 
of  a  board  of  directors  is  the  right  to  place  a  value  on 
property  for  which  stock  is  issued  and,  unless  fraud  can 
be  shown,  this  valuation  will  be  permitted  to  remain  on 


106  INVESTED  CAPITAL  ACCOUNTING 

the  books  of  the  corporation,  but,  for  invested  capital  pur- 
poses, it  does  not  follow  that  the  corporation  will  be  per- 
mitted to  set  up  that  amount,  or  that  value,  as  a  basis 
for  computing  invested  capital.  Therefore,  if  a  business, 
or  other  property  is  purchased  and,  let  us  say,  $500,000, 
par  value,  stock  is  issued  therefor,  it  does  not  necessarily 
mean  that  the  corporation  shall  be  allowed  invested  capital 
to  that  amount  solely  because  of  the  fact  that  it  has  out- 
standing Capital  Stock  to  the  amount  of  $500,000  and  that 
it  carries  the  acquired  assets  at  $500,000. 


If,  upon  investigation,  it  be  found  that  the  property 
taken  in  exchange  for  stock  was  worth  the  par  value  of 
the  stock  issued  for  it,  then  we  must  allow  the  full  amount. 
If  it  be  found  that  the  property  is  worth  less,  then  we  would 
allow  invested  capital,  in  so  far  as  Capital  Stock  is  a  factor, 
only  to  the  extent  of  the  actual  cash  value  of  the  property 
at  the  time  acquired.  Whatever  the  deduction  might  be 
should  be  entered  on  line  2,  Schedule  G. 


To  make  the  matter  more  patent,  as  well  as  further 
to  illustrate  the  matter  of  Treasury  Stock  deduction,  we 
shall  take  the  Balance  Sheets  of  Corporations  A,  B,  C,  D, 
and  E,  which  are  similar  as  to  items  and  amounts,  except 
that  Surplus  requires  different  treatments  according  as  the 
stock  was  issued  for  cash,  for  property  at  actual  cash  value, 
for  property  at  an  inflated  value,  and  where  Treasury  Stock 
is  carried  by  the  corporation.  (We  shall  ignore  any  statu- 
tory adjustments  to  invested  capital  that  are  not  called 
for  in  the  problems,  in  order  to  illustrate  the  various  Bal- 
ance Sheets  and  other  conditions  as  above  specified) . 

Corporation  A  issued  its  stock  for  cash,  at  par.  The 
following  is  its — 


INVESTED  CAPITAL  ACCOUNTING  107 

BALANCE  SHEET 
Assets  Liabilities  and  Capital 

Cash    $50,000   Notes  Payable $100,000 

Plant   200,000    Capital    Stock 300,000 

Sundry  Assets 250,000    Surplus   100,000 


$500,000  $500,000 


No  adjustments  are  necessary.  The  invested  capital 
is  the  amount  of  Capital  Stock,  plus  Surplus— -$400,000. 

Corporation  B  issued  its  stock,  part  for  cash  and  part 
for  plant.  The  amount  issued  for  cash  was  $100,000.  The 
amount  issued  for  plant  was  $200,000.  It  is  agreed  that 
the  plant  was  actually  worth  this  amount  at  the  time  of 
acquisition. 

No  adjustments  are  necessary;  the  invested  capital 
is  Capital  Stock,  plus  Surplus— $400,000. 

Corporation  C  issued  all  of  its  stock  for  plant  and 
other  tangible  property.  It  is  found  that  the  property 
received  for  the  stock  had  an  actual  cash  value  at  the  time 
of  acquisition,  of  $225,000.  The  difference  between  this 
amount  and  the  amount  of  stock  issued  therefor,  must  be 
deducted  and  should  appear  in  line  2,  Schedule  G.  The 
result  is  to  allow  Corporation  C  an  invested  capital  of 
$325,000. 

In  the  case  of  Corporation  D,  Capital  Stock  was  issued 
at  par  value,  for  cash,  and  later,  $75,000  of  the  stock,  par 
value,  was  purchased  by  the  Corporation  at  par  value,  and 
carried  on  the  books  as  Treasury  Stock.  This  is  its — 

BALANCE  SHEET 
Assets  Liabilities  and  Capital 

Cash    $50,000    Notes  Payable $100,000 

Treasury  Stock 75,000    Capital    Stock 300,000 

Plant   200,000    Surplus   175,000 

Sundry  Assets 250,000  .  - 


$575,000  $575,000 


108  INVESTED  CAPITAL  ACCOUNTING 

On  the  basis  of  the  above  Balance  Sheet  the  corpo- 
ration might,  and  probably  would,  claim  an  invested  capital 
amounting  to  $475,000,  but  that  amount  can  not  be  allowed. 
We  must  deduct  the  Treasury  Stock,  leaving  an  invested 
capital  of  $400,000.  This  gives  Corporation  D  the  same 
amount  as  was  given  Corporation  A,  and,  since  the  assets 
are  the  same,  and  the  liabilities  are  the  same,  it  must  be 
the  correct  amount.  At  any  rate,  it  is  equitable  treatment. 

We  have  just  stated  that  the  assets  of  Corporations 
A  and  D  are  the  same,  and  you  may  think  this  statement 
is  erroneous,  inasmuch  as  one  Balance  Sheet  shows  assets 
amounting  to  $500,000,  while  the  other  presents  apparent 
assets  amounting  to  $575,000.  A  study  of  a  corrected  Bal- 
ance Sheet  for  Corporation  D  will  remove  this  impression: 


Assets  Liabilities  and  Capital 

Cash    $50,000   Notes  Payable $100,000 

Plant  200,000    Capital  Stock. $300,000 

Sundry  Assets 250,000    Less  Treasury 

Stock 75,000       225,000 


Surplus  175,000 


$500,000  $500,000 


It  should  now  be  evident  that  the  actual  invested  cap- 
ital of  Corporation  D  is  $400,000,  and  that,  for  invested 
capital  purposes,  Treasury  Stock  can  not  be  treated  as  an 
asset;  that  the  amount  of  stock  outstanding  is  the  amount 
of  stock  issued  LESS  the  stock  returned  to  the  Corporation 
(whether  by  purchase  or  by  gift) . 

And  now  we  come  to  the  so-called  "double  deduction" 
— the  case  of  Corporation  E.  Its  stock  was  issued  under 
conditions  exactly  analagous  to  that  of  Corporation  C,  and 
$75,000  of  the  stock  was  bought  back  at  a  nominal  figure 


INVESTED  CAPITAL  ACCOUNTING  109 

(that  is,  at  a  price  "substantially  less  than  its  par  value") 
or  it  was  returned  to  the  corporation  as  a  gift.  The  fol- 
lowing is  th< 


BALANCE  SHEET  OF  CORPORATION  E 
Assets  Liabilities  and  Capital 

Cash    $50,000  Notes  Payable $100,000 

Treasury  Stock 75,000  Capital  Stock 300,000 

Plant   200,000  Surplus   175,000 

Sundry  Assets 250,000 


$575,000  $575,000 


Is  it  not  clear  that  if  we  do  not  make  the  second  ad- 
justment— an  adjustment  to  Surplus — that  we  will  be 
allowing  Corporation  E  a  greater  amount  of  invested  cap- 
ital than  was  granted  to  Corporation  C,  notwithstanding 
the  fact  that  the  latter  carried  no  Treasury  Stock?  Of 
course,  that  would  be  inequitable.  The  deduction  must  be 
made  as  to  Treasury  Stock,  and,  since  the  property  acquired 
for  stock  was  not  worth  the  par  value  of  the  stock  issued 
therefor,  a  second  adjustment  also  must  be  made,  as  fol- 
lows: 


Schedule  II — Invested  Capital 

Taxable 
Year 

Line  1   (see  Form  1120)  for'd  from  Schedule  E $400,000 

Line  4  From  Schedule  G 75,000 


Line  9  Invested  Capital $325,000 


110  INVESTED  CAPITAL  ACCOUNTING 

Schedule  E 

Line  3 $300,000 

Line  5 175,000 

$475,000 
Line  9 75,000 


$400,000 

Schedule  G 
Line  2..  ..$75,000 


If  the  corporation  had  purchased  the  Treasury  Stock 
at,  let  us  say,  75%  of  its  par  value  and  it  carried  this  stock 
as  an  asset  at  the  amount  paid  for  it,  then  the  amount 
paid  (which  in  this  instance  would  be  the  book  value)  is 
the  amount  to  be  deducted  and  entered  in  line  9,  Schedule 
E,  and  not  the  par  value.  See  Article  862. 

If  the  Treasury  Stock  was  acquired  by  gift,  or  at  a 
price  "substantially  less  than  its  par  value,"  and  if  the 
corporation  can  show  to  the  satisfaction  of  the  Commis- 
sioner that  the  property  for  which  the  stock  was  issued 
was  actually  worth  the  par  value  of  the  stock  issued,  it 
would  appear  that  the  second  adjustment  would  not  be 
made.  But  the  burden  of  proof  would  be  wholly  upon  the 
corporation  and  the  evidence  would  have  to  be  conclusive. 
The  writer  is  unable  to  cite  any  authority  for  the  above 
statement,  but  inasmuch  as  it  would  be  nothing  more  than 
fair  treatment,  it  is  believed  that  such  procedure  would  be 
sanctioned.  Of  course,  if  the  reacquired  stock  was  paid 
for  in  cash,  there  can  be  no  question  as  to  allowing  the 
corporation  to  set  up  a  Paid-in  Surplus  equal  to  the  amount 
of  cash  that  was  received  for  the  stock. 


INVESTED  CAPITAL  ACCOUNTING  111 

Value  Greater  Than  Par  Value  of  Stock  Issued  Therefor 

Take  the  case  of  a  close  corporation,  organized  before 
any  one  dreamed  of  an  excess  profits  tax.  Four  men,  for 
example,  own  a  business  as  partners.  They  decide  to  in- 
corporate. The  plant  is  worth,  in  cash,  $1,000,000.  Each 
owns  a  one-fourth  interest.  So  far  as  they  might  be  con- 
cerned, it  would  be  immaterial  whether  their  holdings  were 
represented  by  one  share  of  stock  the  par  value  of  which 
was  $10,  or  by  2,500  shares  at  a  par  value  of  $100.  Each 
would  draw  one-fourth  of  the  profits  in  the  shape  of  divi- 
dends. But  they  incorporate,  let  us  assume,  in  1910,  for 
$200,000  and  issue  to  themselves  stock  to  that  amount, 
each  receiving  $50,000  in  stock,  and  the  business  is  trans- 
ferred to  the  corporation.  Nothing  affects  them  in  the 
least  until  the  advent  of  Excess  and  War  Profits  taxes, 
when  it  at  once  becomes  desirable  to  show  as  large  an 
invested  capital  as  possible.  They  simply  had  incorporated 
for  $200,000  and  turned  their  plant  over  to  the  corporation 
for  $200,000  in  stock.  No  Surplus  was  set  up.  They  did 
not  feel  any  necessity  for  so  doing.  But  now,  in  1919,  they 
wish  to  set  up  a  Paid-in  Surplus,  based  on  the  actual  value 
of  the  plant  as  at  the  time  that  the  corporation  acquired 
it,  less  fair  depreciation.  Shall  it  be  permitted  the  cor- 
poration to  do  this?  Yes!  The  corporation  has  the  same 
right  to  do  this  as  the  Government  would  have  to  reduce 
the  surplus  that  some  other  corporation  had  set  up  and 
which  surplus  was  based  on  an  inflated  or  an  appreciated 
value.  This  adjustment  should  be  made  in  Schedule  F. 
Study  Articles  836  and  837 ;  also  840  and  843. 

Before  allowing  any  such  surplus  to  be  included  in 
invested  capital,  care  must  be  taken  to  see  that  all  actual 
depreciation,  depletion,  and  (or)  obsolescence  has  properly 
been  charged  off  from  the  date  of  acquisition  of  the  prop- 
erty down  to  the  beginning  of  the  taxable  year.  Also,  that 
&ny  deficit,  other  than  an  operating  deficit  (see  Digest  No. 


112  INVESTED  CAPITAL  ACCOUNTING 

9,  page  193 — 1-19-129),  that  may  have  occurred  has  been 
made  good.  The  subjects  of  depreciation,  etc.,  are  covered 
in  subsequent  chapters. 


Partially-Paid-for  Stock 

Sometimes  corporations  sell  stock  to  employees,  offi- 
cers, or  others,  to  be  paid  for  on  the  installment  plan, 
which  installments,  in  the  case  of  employees  or  officers,  are 
usually  deducted  from  the  weekly  or  monthly  salary.  It 
is  seldom  that  the  stock  is  actually  issued  before  the  full 
amount  has  been  paid.  But,  regardless  as  to  whether  or 
not  the  stock  actually  has  been  issued,  the  amount  that 
can  be  included  in  invested  capital  is  the  amount  that  the 
subscriber  has  actually  paid  on  the  contract,  regarding 
"paid"  as  being  the  amount  legitimately  deducted  from  the 
pay  envelope,  and  being  based  on  a  salary  or  wage  figure 
that  is  not  excessive  for  the  kind  or  class  of  services  per- 
formed by  the  subscriber. 


In  the  event  that  an  enforceable  note  or  other  obliga- 
tion has  been  accepted  by  the  corporation  in  lieu  of  cash 
payment  of  stock,  the  obligation,  whether  or  not  it  bears 
interest,  is  regarded  as  payment  for  the  stock;  provided, 
that  the  jurisdiction  under  which  the  concern  is  incorpo- 
rated permits  the  taking  of  such  obligations  in  payment  of 
stock,  and,  also,  provided  that  the  payment  of  the  note  or 
other  obligation  is  not  in  any  manner  contingent  upon  the 
earnings  of  the  corporation.  See  Article  833.  Unpaid  sub- 
scriptions to  capital  stock  do  not  constitute  invested  cap- 
ital. If  the  notes  that  are  given  in  payment  of  stock  are 
non-interest  bearing,  the  amount  allowable  would  be  the 
actual  cash  value  of  the  notes;  that  is,  the  discount  value 
of  the  notes. 


INVESTED  CAPITAL  ACCOUNTING  113 

Bonus  Stock 

Capital  stock  is  sometimes  issued  as  a  bonus  in  con- 
nection with  the  sale  of  the  bonds  of  a  corporation.  To 
determine  the  amount  to  be  included  in  invested  capital 
(always  remembering  that  borrowed  money,  whether  in 
the  form  of  bonds,  or  otherwise,  can  not  be  made  a  part 
of  invested  capital)  ascertain  the  amount  the  corporation 
could  have  realized  from  the  sale  of  the  bonds  had  no  bonus 
stock  been  given  with  the  bonds.  The  difference  between 
this  amount  and  the  amount  for  which  the  bonds  and  the 
stock  was  sold,  is  the  measure  of  the  value  received  for 
the  bonus  stock,  and  that  amount  may  be  included  in  in- 
vested capital. 

For  example,  the  X  Corporation  issues  50  bonds  having 
a  face  value  of  $1,000  each.  With  each  bond  it  gives,  as 
a  bonus,  one  share  of  its  capital  stock,  par  value  $100.  The 
amount  received  for  the  bonds  thus  issued  is,  let  us  say, 
$40,000.  Upon  investigation,  we  find  that  without  the 
bonus  stock  feature,  the  bonds  would  have  brought  $38,000 ; 
hence,  the  invested-capital  value  to  be  placed  on  the  $5,000 
capital  stock  given  with  the  bonds  is  $2,000.  See  Ar- 
ticle 832. 

Stock  Dividends 

Stock  dividends  do  not  affect  invested  capital.  See 
and  study  Articles  859-860.  Why?  Assume  a  Balance 
Sheet  something  like  this — 


Assets  Liabilities  and  Capital 

Cash $100,000   Accounts  Payable $75,000 

Accounts  Receivable 50,000  Capital   Stock   Outstand- 

Plant   200,000       ing    125,000 

Sundry  Assets 150,000    Surplus   300,000 


$500,000  $500,000 


114  INVESTED  CAPITAL  ACCOUNTING 

No  divergent  question  entering  into  the  above,  the 
invested  capital  is  $425,000,  Capital  Stock  plus  Surplus. 
Now  a  stock  dividend  is  declared  and  issued.  Surplus  is 
charged  $200,000  and  Capital  Stock  is  credited  with  a  like 
amount  and  then  the  Balance  Sheet  reads  thus — 


Assets  Liabilities  and  Capital 

Cash $100,000   Accounts  Payable $75,000 

Accounts  Receivable 50,000  Capital    Stock   Outstand- 

Plant   200,000       ing .325,000 

Sundry  Assets 150,000    Surplus   100,000 


$500,000  $500,000 


Invested  capital  is  still  $425,000 — Capital  Stock  plus 
Surplus.  All  that  has  happened  is  to  reduce  one  account 
and  increase  another — both  being  on  the  same  side  of  the 
Balance  Sheet. 


More  About  Treasury  Stock 

(a)  If  at  any  time  during  the  taxable  year  a  corpo- 
ration sells  Treasury  Stock  which  it  held  at  the  beginning 
of  the  period,  or  which  it  may  have  acquired  during  the 
period  under  review,  the  proceeds  (here,  par  value  has  no 
significance)  of  the  sale  are  to  be  included  in  invested  cap- 
ital, effective  as  of  the  date  of  the  sale. 

(b)  If  at  any  time  during  the  taxable  year  a  cor- 
poration acquires  its  own  stock,  invested  capital  for  the 
taxable  year  must  be  reduced  in  an  amount  equal  to  the 
amount  that  the  corporation  paid  for  the  stock,  effective 
as  at  the  date  of  purchase;  provided,  however,  if  at  the 
time  of  purchase,  there  were  undivided  profits  over  and 
above  the  accrued  income  and  profits  taxes  for  the  taxable 


INVESTED  CAPITAL  ACCOUNTING  115 

year  sufficient  to  purchase  the  stock,  then  invested  capital 
is  not  deemed  to  be  subject  to  reduction  by  reason  of  the 
purchase  by  the  corporation  of  its  own  stock.  If  the  free 
earnings  (undivided  profits)  are  partly  sufficient  to  cover 
the  cost  of  the  stock  purchased,  then  invested  capital  is 
to  be  reduced  to  the  extent  that  the  available  earnings  are 
not  sufficient  to  make  the  purchase. 

Note  that  in  this  connection,  par  value  has  no  bearing ; 
it  is  the  cost  (to  the  corporation)  of  the  stock  against  which 
the  earnings  are  to  be  applied.  See  Article  862.  If,  how- 
ever, as  previously  explained,  the  corporation  acquired  the 
stock  prior  to  the  taxable  year,  and  carries  it  as  an  asset 
at  a.i  amount  different  from  the  cost,  the  amount  of  deduc- 
tion is  the  book  value. 

To  illustrate:  (a)  Corporation  X  sells,  September  3, 
1918,  $50,000  of  its  Treasury  Stock  for  $30,000.  This 
amount  ($30,000)  is  added  to  invested  capital  for  a  period 
of  120  days,  hence — 

120/365x$30,000=$9,863.02,  the  average  amount  to  be 
added  to  invested  capital. 

(b)  September  3,  1918,  the  Y  Corporation  purchased 
300  shares  of  its  own  stock,  par  value  $100,  for  $32,000. 
The  earnings  up  to  that  date  amounted  to  $67,000.  A  divi- 
dend of  $10,000  had  been  paid  July  1.  The  accrued  income 
and  profits  taxes  amounted  to  $12,000. 


Earnings  up  to  date  of  purchase $67,000 

Less  dividend  paid  July  1 $10,000 

accrued  taxes 12,000       22,000 


Available  for  purchase  of  stock $45,000 


Cost  of  stock $32,000 

Earnings  available 45,000 


116  INVESTED  CAPITAL  ACCOUNTING 

The  earnings  available  being  sufficient  to  cover  the 
purchase,  no  deduction  from  invested  capital  is  required. 

(b-2)  September  3,  1918,  the  Z  Corporation  purchased 
300  shares  of  its  own  stock,  par  value  $100,  for  $32,000. 
The  earnings  up  to  that  date  were  $48,000.  A  dividend  of 
$18,000  had  been  paid  July  1.  The  accrued  income  and 
profits  taxes  amounted  to  $20,000. 

Earnings  up  to  date  of  purchase $48,000 

Less  dividend  paid  July  1 $18,000 

Less  accrued  taxes 20,000      38,000 

Available  for  purchase  of  stock $10,000 


Cost  of  stock $32,000 

Earnings  available 10,000 

Invested  capital  reduced $22,000 

Inasmuch  as  invested  capital  was  reduced  for  a  period 
of  only  120  days,  we  must  find  the  average  reduction  for 
the  year,  as  follows: 

120/365x$22,000=$7,232.88,  the  average  amount  by 
which  invested  capital  must  be  reduced  by  reason  of  this 
purchase  of  Treasury  Stock.  See  Articles  853  and  854  (b). 

Equality  of  Treatment 

A  number  of  auditors  have  held  the  view  that  to  give 
more  invested  capital  to  a  concern  whose  stock  was  returned 
as  a  gift  than  would  be  given  to  one  that  purchased  the 
stock  (all  else  being  equal)  would  not  be  equitable  treat- 
ment. This  view  can  only  be  premised  on  the  thought  that 
when  a  concern  buys  in  its  own  stock  the  transaction  would 
be  analogous  to  the  purchase  of  some  other  thing,  as  a 
machine,  or  a  building. 

The  underlying  misconception  is  the  result  of  erro- 
neously regarding  Treasury  Stock  as  an  asset.  When  a 


INVESTED  CAPITAL  ACCOUNTING  117 

machine  is  purchased,  one  asset  is  exchanged  for  another 
and  the  investment  of  the  stockholders  is  unchanged.  When 
Treasury  Stock  is  purchased,  an  asset  goes  back  to  the 
stockholder  in  exchange  for  a  stock  certificate  that  has  no 
more  intrinsic  value  than  has  unissued  stock. 

The  following  illustrations  may  clear  the  matter  up: 

Balance  Sheet  of  Corporation  M  before  purchase  of 
its  stock — 

Assets  Liabilities  and  Capital 

Cash $100,000  Notes  Payable $90,000 

Accounts    Receivable 50,000  Capital  Stock 250,000 

Plant   350,000  Surplus  160,000 


$500,000  $500,000 


The  invested  capital  expressed  by  the  above  is  $410,000. 

It  is  understood  that  in  the  illustrations  below, 
the  stock  was  issued  for  cash  at  par,  and  that  the  assets 
are  stated  at  true  value. 

Now  we  shall  assume  that  Corporation  M  purchases 
$50,000,  par  value,  of  its  capital  stock,  and  this  journal 
entry  is  made — 

Treasury  Stock $50,000 

Cash  $50,000 

(Suitable  explanation) 

Its  Balance  Sheet  will  now  be  as  follows : 

Assets  Liabilities  and  Capital 

Cash $50,000   Notes  Payable $90,000 

Accounts  Receivable 50,000    Capital  Stock.  .$250,000 

Plant   350,000    Less  Treasury 

Stock    50,000     200,000 

Surplus 160,000 

$450,000  $450,000 


118  INVESTED  CAPITAL  ACCOUNTING 

The  invested  capital  is  now  $360,000.  It  should  be 
clear  to  you  that  when  the  stock  was  acquired  cash  went 
out — $50,000  that  had  been  invested  by  stockholders  was 
returned  to  them,  and  is  no  longer  invested  in  the  en- 
terprise. 

In  the  following  illustration  we  assume  that  the  Treas- 
ury Stock  was  donated  to  the  corporation,  and  that  the 
following  (or  a  similar)  journal  entry  was  made: 


Treasury  Stock $50,000 

Donated  Surplus $50.000 

(Suitable  explanation) 


The  Balance  Sheet  would  reflect  the  following: 


Assets  Liabilities  and  Capital 

Cash $100,000   Notes  Payable $90,000 

Accounts  Receivable 50,000    Capital  Stock.  .$250,000 

Plant   350,000    Less  Treasury 

Stock    50,000     200,000 

Surplus   160,000 

Donated  Surplus 50,000 


$500,000  $500,000 


The  invested  capital  is  $410,000  for  the  reason  that 
when  the  Treasury  Stock  was  acquired,  nothing  that  had 
been  invested  by  the  stockholders  was  returned  to  them. 

If  this  Treasury  Stock  is  later  sold,  the  invested  capital 
will  be  increased  by  the  amount  realized  from  the  sale, 
prorated  as  at  the  date  of  sale. 


INVESTED  CAPITAL  ACCOUNTING  119 

Capital  Stock  Averaged 

In  the  event  that  during  the  taxable  year  a  corporation 
issues  additional  stock,  the  amount  received  for  the  addi- 
tional stock  issued  is  to  be  added  to  invested  capital  as 
at  the  date  of  issue.  Assuming  that  the  M  Corporation 
issued  additional  stock  in  the  amount  of  $80,000,  at  its  par 
value,  $100,  September  3,  1919,  the  amount  received  ($80,- 
000)  is  added  to  invested  capital  for  a  period  of  120  days, 
hence — 

120/365x$80,000=$26,301.37,  the  average  amount  to 
be  added  to  invested  capital  for  the  year,  by  reason  of  the 
issuance  of  this  amount  of  additional  stock.  See  Article  853. 

Fraction  of  a  Year 

This  feature  is  so  clearly  covered  by  Article  855  that 
further  observations  are  deemed  unnecessary.  You  should 
make  a  careful  study  of  this  Article  and  work  out  the  illus- 
tration. 

Borrowed  Capital 

It  can  not  be  too  frequently  asserted  that  borrowed 
capital  can  not  be  included  in  invested  capital. 

Some  taxpayers  are  very  clever  in  their  efforts  to  con- 
vince us  that  borrowed  capital  should  be  considered,  in  their 
particular  case,  as  invested  capital.  A  case  comes  to  mind : 
a  man  owning  99%  of  the  capital  stock  of  a  corporation, 
borrowed  from  his  bank,  in  the  name  of  the  corporation, 
$35,000  and  gave,  individually,  as  security  for  the  payment 
of  the  loan,  a  first  mortgage  on  his  residence  property.  He 
contended  that,  to  all  intents  and  purposes,  this  property 
was  an  asset  of  the  corporation  and  should  be  so  regarded 
by  the  Bureau,  inasmuch  as  this  property  was  the  means 
whereby  the  corporation  was  enabled  to  procure  the  loan; 
that  so  long  as  this  mortgage  remained  unpaid  he  could 
not  sell  the  property  and  realize  anything  on  it  himself, 


120  INVESTED  CAPITAL  ACCOUNTING 

and,  further,  that  in  case  the  loan  was  not  paid  by  the 
corporation,  the  bank  could  foreclose  on  the  mortgage  and 
sell  the  property  for  the  corporation's  debt;  that  since  the 
property  was  pledged  for  the  payment  of  a  debt  owed  by 
the  corporation,  it  was  a  corporation  asset  just  as  much  as 
any  item  carried  on  the  Balance  Sheet  of  the  corporation 
that  might  be  pledged  for  the  payment  of  a  loan.  It  sounds 
plausible,  does  it  not?  His  contentions  were  not  looked 
upon  favorably.  The  $35,000  was  borrowed  capital,  and 
not  invested  capital. 


Gain  or  Loss  in  the  Sale  of  Capital  Stock 

If  a  corporation  sells  its  own  stock  below  the  par  value 
of  the  stock,  there  is  no  deductible  loss  by  reason  of  the 
transaction,  and,  per  contra,  if  a  corporation  sells  its  own 
capital  stock  at  a  price  above  the  par  value  of  the  stock, 
no  taxable  income  is  to  be  returned  by  reason  of  the  trans- 
action. See  Articles  542  and  563.  Note  particularly  that 
Article  542  states :  "The  proceeds  (not  the  par  value)  from 
the  original  sale  by  a  corporation  of  its  capital  stock 
*  *  *  constitute  the  capital  of  the  company." 


Capitalizing  a  Bargain 

In  the  event  that  a  corporation  secures,  directly  or 
indirectly,  as  through  its  stockholders  or  through  an  agent 
acting  for  it,  property  at  a  bargain  price  (actual  bargain 
or  presumed-to-be-bargain),  as,  for  example,  at  a  fore- 
closure, or  other  forced  sale,  a  Paid-in  Surplus  may  not  be 
set  up  on  the  basis  that  the  property  was  worth  more  than 
it  cost  the  corporation.  In  other  words,  you  cannot  cap- 
italize a  bargain.  Article  836.  But  see  also,  and  study 
Article  837.  Always  bear  in  mind  that  cost  to  the  cor- 
poration is  the  determining  factor. 


INVESTED  CAPITAL  ACCOUNTING  121 

The  Meat  in  the  Cocoanut 

The  whole  matter  as  to  whether  any  given  item  is  to 
be  regarded  as  invested  capital  or  as  borrowed  capital, 
resolves  itself  into  this  question:  Does  the  obligation  take 
precedence  over,  or  stand  on  an  equality  with,  general 
creditors  ?  If  it  does,  then  it  must  not  be  classed  as  invested 
capital ;  otherwise,  it  is  pretty  safe  to  include  it  in  invested 
capital. 

Of  course,  all  questions  regarding  invested  capital  may 
not  be  summed  up  in  the  above  question,  but  any  question 
having  to  do  with  proprietorship  money,  and  with  creditor- 
ship  money,  may  be  decided  on  the  basis  of  the  formula 
given. 

Things  to  Remember 

1.  The  value,  in  dollars,  that  a  corporation  receives 
for  its  stock,  is  the  amount  of  invested  capital  that 
is  contributed  by  the  Capital  Stock  of  the  corpora- 
tion. 

2.  Treasury  stock  may  not  be  regarded  as  an  asset, 
and  is  not  considered  as  being  "stock  outstanding." 
And,  further,  when  Treasury  Stock  is  purchased 
by  the  corporation,  a  portion  of  the  contribution 
mentioned  under  1,  above,  goes  out. 

3.  Any  change  made  in  the  amount  of  stock  outstand- 
ing during  the  taxable  year,  must  be  averaged  as 
at  the  date  of  the  change. 

4.  Borrowed  capital  is  not  invested  capital. 

5.  The  sum  of  the  assets  can  not  be  regarded  as  being 
the  measure  of  invested  capital.    Under  only  one 
condition  does  the  invested  capital  and  the  sum  of 
the  assets  form  an  equation,  and  it  is  far  from 


122  INVESTED  CAPITAL  ACCOUNTING 

likely  that  you  will  ever  have  occasion  to  audit 
such  a  case. 

6.  Stock  returned  to  the  treasury  as  a  gift,  or  at  a 
price  "substantially  less  than  its  par  value,"  and 
having  been  issued  for  property,  tangible  or  in- 
tangible (these  will  be  explained  in  the  chapter  on 
Tangibles  and  Intangibles),  is  regarded  as  not 
having  been  issued  for  property.  Not  only  is  the 
amount  of  Treasury  Stock  to  be  deducted  from  the 
amount  of  stock  issued,  to  obtain  the  amount  of 
stock  outstanding,  but  Surplus  must  be  reduced  by 
the  amount  of  inflation  brought  about  by  the  in- 
flated value  placed  upon  the  property  received  for 
the  stock. 


CHAPTER  EIGHT 
SURPLUS— RESERVES— FUNDS 

Importance  of  Surplus 

The  most  important  factor  in  building  up  invested 
capital  is  Capital  Stock — how  much  did  it  contribute  to 
the  business?  The  item  next  in  importance,  in  fact,  the 
only  other  item  of  great  consequence,  is  Surplus — how  did 
a  given  amount  find  a  place  on  the  balance  sheet;  did  it 
get  there  by  the  directors  allowing  a  part  of  the  concern's 
actual  corporate  earnings*  to  remain  in  the  business,  or 
through  contributions  of  stockholders  (or,  perhaps,  by 
others)  in  excess  of  the  par  value  of  the  stock  issued  to 
them?  If  so,  it  is  a  part  of  invested  capital.  If  it  got 
there  in  some  other  way,  as  for  example,  by  inflation  of 
asset  values,  by  writing  up  assets  to  actual  present  value, 
by  the  arbitrary  creation  of  good  will,  by  failure  to  record 
certain  liabilities,  by  failure  to  charge  off  sufficient  depre- 
ciation or  other  proper  expenses,  or  by  any  other  means 
the  portion  of  Surplus  so  created  can  not  be  included  in 
invested  capital. 

What  is  Surplus? 

Surplus  is  the  excess  of  assets  over  the  total  of  lia- 
bilities plus  the  amount  of  Capital  Stock  outstanding. 

Conceivably  there  could  be  an  actual  Surplus  and  at 
the  same  time  it  might  not  be  in  evidence  on  the  balance 

*Note  the  use  of  the  term  "corporate  earnings,"  instead  of  "net 
operating  income."  The  former  rightfully  would  include  "non-operat- 
ing income." 


124  INVESTED  CAPITAL  ACCOUNTING 

sheet.  Such  a  condition  could  arise  in  the  case  of  a  cor- 
poration issuing  stock  of  no-par  value.  Assume  that  the 
X  Corporation  has  outstanding  5,000  shares  of  no-par  stock 
for  which  it  received  $60  a  share.  During  past  periods  it 
has  allowed  net  earnings  amounting  to  $25,000  to  remain 
in  the  business.  Some  bookkeepers  would  credit  the  stock 
account  with  the  earnings,  showing  a  balance  sheet  some- 
what like  the  following: 


Assets  Liabilities  and  Capital 

Cash $50,000  Accounts  Payable $25,000 

Sundry  Assets 300,000  No-par  Value  Stock  5,000 

shares  outstanding 325,000 


$350,000  $350,000 


Such  technique  is  very  bad,  but  since  we  have  no  con- 
trol over  the  bookkeepers,  we  cannot  dictate  to  them  how 
they  shall  keep  their  books.  When  there  is  a  surplus  it 
should  be  shown  as  a  separate  account  precisely  as  it  would 
be  shown  were  the  stock  of  the  usual  par-value  variety, 
thus — 


Assets  Liabilities  and  Capital 

Cash $50,000   Accounts  Payable $25,000 

Sundry  Assets 300,000    Capital     Stock  —  5,000 

shares  of  no-par  value 

issued  for 300,000 

Surplus   25,000 


$350,000  $350,000 


INVESTED  CAPITAL  ACCOUNTING  125 


Broadly  speaking,  there  are  two  kinds  of 
Earned  Surplus  and  Paid-in  Surplus.  Other  terms  are 
sometimes  used,  such  as  Donated  Surplus,  Capital  Surplus, 
etc.  Usually,  Surplus  is  included  in  invested  capital,  but 
not  necessarily  so;  neither  need  all  of  it  be  included,  as 
we  shall  see  as  we  go  along. 

For  invested  capital  purposes,  Earned  Surplus  may 
consist  of  earnings  accumulated  during  the  period  or  periods 
preceding  the  taxable  year,  and  (or)  of  profits  realized 
from  the  sale,  previous  to  the  taxable  year,  of  capital  assets. 
Occasionally,  it  may  come  from  other  sources,  as,  for  exam- 
ple, insurance  received  in  excess  of  the  actual  loss  to  the 
corporation. 

From  the  viewpoint  of  good  accounting  practice,  a  dis- 
tinction should  be  made  between  earnings  and  profits  as 
here  mentioned,  but  for  our  purpose,  this  technical  dis- 
tinction need  not  be  observed.  Study  Article  838. 

Paid-in  Surplus,  real  or  so-called,  may  be  the  result 
of  various  transactions,  such  as  — 

(1)  If  the  capital  stock  be  not  non-assessable,  an 
assessment  might  be  made  on  the  stockholders  for 
the  purpose  of  procuring  working  capital,  or,  the 
stockholders  might  voluntarily  contribute  to  a 
working  fund.  See  Article  543. 

To  illustrate,  stock  outstanding  might  be  $500,- 
000.  The  corporation  needs  ready  cash  and  the 
stockholders  are  assessed,  or  voluntarily  pay  in, 
50%  based  on  the  holdings  of  each,  after  which 
the  Balance  Sheet  might  appear  something  like 
the  following: 


126  INVESTED  CAPITAL  ACCOUNTING 

Assets  Liabilities  and  Capital 

Cash $300,000   Notes  Payable $100,000 

Sundry  Assets 600,000    Capital    Stock 500,000 

Paid-in  Surplus 250,000 

Earned    Surplus 50,000 


$900,000  $900,000 


(2)  The  original  sale  of  Capital  Stock  might  be  at  a 
price  above  par,  in  which  event  the  amount  realized 
above  the  par  value  of  the  stock  would  be  Paid-in 
(or  Contributed)  Surplus — sometimes  called 
Capital  Surplus.  Possibly  it  would  appear  on  the 
Balance  Sheet  as  Premium  on  Capital  Stock,  as — 

Assuming  that  2,000  shares  of  a  certain  stock, 
having  a  par  value  of  $100  a  share  was  sold  by  the 
corporation  at  $120.  We  should  find  on  the  books 
something  like  this : 


Assets  Liabilities  and  Capital 

Cash $50,000   Accounts  Payable $60,000 

Sundry  Assets 250,000    Capital    S,tock 200,000 

Paid-in  Surplus 40,000 


$300,000  $300,000 


But  note  this:  Transfer  of  stock  or  shares  be- 
tween parties  neither  of  whom  is  the  corporation, 
does  not  affect  invested  capital  no  matter  how 
much  the  stock  may  bring  above  par  or  how  much 
below  par.  The  only  time  that  the  amount  the 
stock  brings,  has  any  bearing  on  invested  capital 
is  when  that  amount  is  paid  directly  to  the  cor- 
poration. One  may  pay  to  a  stockholder  $200  for 


INVESTED  CAPITAL  ACCOUNTING  127 

a  share  having  a  par  value  of  $100  and  such  a  one 
has  invested  $200  in  that  share  of  stock,  but  the 
corporation  did  not  receive  the  invested  sum.  Its 
invested  capital  is  based  on  what  the  original 
holder  of  the  share  gave  for  it  to  the  corporation. 

If  one  pays  $200  for  a  share  of  stock  having  a  par 
value  of  $100  there  must  be  some  reason  for  paying  such 
a  premium.  The  usual  reasons  are — 

(a)  Earning  power  of  the  corporation  resulting  in 
an  unusually  large  dividend  percentage. 

Big  earning  power  does  not  affect  invested 
capital  unless  the  earnings  remain  in  the  busi- 
ness, and  even  then,  the  invested  capital  for 
the  year  in  which  the  earnings  are  realized 
,  is  not  affected,  but  the  succeeding  year's  in- 
vested capital  would  be,  provided,  as  stated, 
that  the  earnings  remain  in  the  business, 
either  as  Surplus  or  as  Surplus  charged  with 
a  stock  dividend. 

(b)  A  big  excess  of  assets  over  capital  stock  and 
liabilities,  resulting  in  a  large  surplus. 

Since  Earned  Surplus  is  included  in  invested 
capital  it  might  be  said  that  the  $200  paid  for 
a  $100  share  is  invested  capital — $100  repre- 
sented by  the  stockholder's  equity  in  the  Sur- 
plus. The  invested  capital,  however,  has  not 
been  changed  by  the  payment  (to  a  stock- 
holder) of  $200  for  a  $100  share— the  invest- 
ment was  there  before  the  transfer  of  stock. 

(c)  A  desire  to  obtain  control  of  the  concern. 

In  this  instance  a  great  difference  is  appar- 
ent. Assume  first,  Mr.  H.  can  control  cor- 
poration Y  by  becoming  the  owner  of  ten  addi- 


128  INVESTED  CAPITAL  ACCOUNTING 

tional  shares  of  stock.  He  buys  the  shares 
from  Mr.  J.  and  pays  $10,000  for  the  ten  shares 
the  par  value  of  which  is  $1,000.  Invested 
capital  is  not  changed.  Second  assumption: 
There  are  ten  unissued  shares,  or  there  are 
ten  shares  of  Treasury  Stock  and  Mr.  H.  pays 
$10,000  for  them.  Invested  capital  is  increased 
by  $10,000  as  at  the  date  of  sale  of  the  shares. 
In  either  event  the  money  was  invested  by  Mr. 
H,  but  in  the  first  instance  it  did  not  go  into 
the  business;  under  the  second  assumption, 
the  money  went  into  the  treasury  of  the  cor- 
poration. 

(3)  In  some  instances  it  might  consist  of  gain  derived 
from  the  redemption  of  the  corporation's  bonds  at 
a  price  less  than  the  selling  price,  or  in  bonds  being 
donated  back  to  the  corporation  by  the  purchaser. 

(4)  Infrequently  it  may  be  found  that  Surplus  is  the 
result  of  the  forfeiture  of  stock  partly  paid  for. 
It  sometimes  happens  that  purchasers  of  stock, 
failing  to  carry  out  the  agreement,  forfeit  their 
right  to  the  stock,  and  to  whatever  amount  they 
may  have  paid  on  it.    The  amount  they  had  paid 
on  the  stock,  in  this  event,  would  become  Paid-in 
Surplus. 

In  many  of  the  states  this  could  not  happen  for 
the  corporation  would  be  required  to  pay  to  the 
original  subscriber  any  excess.  Thus,  to  illustrate, 
B  pays  $4,000  in  installments  on  Stock  Purchase 
Contract  calling  for  $10,000  and  defaults  on  the 
balance.  The  corporation  sells  the  stock  to  C  for 
$8,000.  Under  the  laws  of  some  states  there  would 
be  created  Surplus  by  Default,  $2,000.  In  other 
states  the  corporation  would  have  to  return  $2,000 
to  the  original  subscriber. 


INVESTED  CAPITAL  ACCOUNTING  129 

(5)  This  subdivision  has  to  do  with  Surplus  created 
by  the  return  of  Capital  Stock  as  a  gift.     This 
matter  is  covered  in  the  chapter  on  Capital  Stock. 

(6)  Certain  of  the  assets  might  actually  have  appre- 
ciated in  value,  or  their  value  might  have  been 
arbitrarily  written  up.    The  book  value   (real  or 
supposititious)  over  the  cost  of  the  asset  would  be 
a  credit  to  the  so-called  Paid-in  Surplus.    Or,  since 
there  is  no  standard  accounting  terminology  for 
such  items,  this  supervalue  might  be  credited  to 
an  account  called  Earned  Surplus.    That  would  not 
be  good  accounting  procedure. 

The  items  (1),  (2),  (3),  and  (4)  are  properly  included 
in  invested  capital.  Surplus  created  as  under  (6)  must 
not  be  included  in  the  computation  of  invested  capital. 
Item  (5)  is  explained  in  Chapter  Seven.  Study  the  article 
in  Bulletin  18-20,  page  17. 

Divisions  of  Surplus — Reserves 

All  of  the  actual  Surplus  is  not  always  embraced  within 
the  terms  or  names  previously  mentioned.  Undivided 
Profits  is,  in  effect,  Surplus  for  invested  capital  purposes. 
Do  not  fail  to  observe,  however,  that  the  account,  Undivided 
Profits,  must  receive  the  same  close  scrutiny  that  should 
be  accorded  to  Surplus.  It  is  just  as  easy  to  make  entries 
showing  erroneous  undivided  profits  as  it  is  to  make  entries 
that  will  produce  an  overstated  Surplus. 

All  true  reserves  are  mere  bookkeeping  divisions  of 
Surplus — Surplus  set  aside  for  some  definite  purpose — and 
must  be  included  in  invested  capital. 

Note  the  designation,  TRUE  RESERVES.  All  accounts 
labeled  "reserves"  are  not  true  reserves.  Many  of  them 
are  not  reserves  at  all.  A  True  Reserve  is  an  allocation 
of  SurDlus.  or.  as  it  is  sometimes  called,  Appropriated  Sur- 


130  INVESTED  CAPITAL  ACCOUNTING 

plus.  Some  reserves,  while  they  may  appear  to  be  alloca- 
tions of  Surplus,  are  in  actuality,  Valuation  Accounts,  or, 
Suspended-Credit  Reserves. 

Bear  this  in  mind— a  TRUE  RESERVE  is  properly 
reflected  on  the  asset  side  of  the  Balance  Sheet  in  assets 
of  equal  value.  Any  other  reserve  (so-called)  should  indi- 
cate to  you  that  the  values  of  the  assets  are  overstated. 

The  most  glaring  misuse  of  the  term  "reserve"  is  in 
the  account,  Reserve  for  Depreciation.  Its  misuse  is  all 
the  more  unfortunate  because  of  its  almost  universal  adop- 
tion to  represent  something  that  is  not  an  actual  liability; 
it  is  not  Net  Worth ;  but  it  is  often  found  on  the  Liability- 
Net  Worth  side  of  the  Balance  Sheet. 

What  it  really  is,  is  hard  to  define,  but  its  true  func- 
tion is  to  reduce,  instead  of  reflect,  the  values  shown  on 
the  asset  side.  By  some  accountants  it  is  called  a  Negative 
Reserve  (it  is  negative,  but  it  is  not  a  reserve).  By  other 
accountants  it  is  called  a  Suspended-Credit  Reserve.  These 
names  are  seldom  given  the  account  by  bookkeepers — they 
are  applied  by  accountants  in  their  struggle  to  find  an  appro, 
priate  name  for  the  account.  The  Interstate  Commerce 
Commission  requires  that  the  term,  Accrued  Depreciation, 
be  used.  For  reasons  not  necessary  to  mention  here,  this 
appellation  is  objectionable. 

It  is  true  that  there  might,  or  could,  be  a  TRUE  Re- 
serve for  Depreciation;  that  is,  functional  depreciation — 
almost  equivalent  to  Inadequacy  or  Obsolescence,  but  such 
a  reserve  is  seldom  seen  on  a  Balance  Sheet. 

Practically  all  accounts  called  Reserve  for  Deprecia- 
tion are  not  reserves  at  all.  They  should  be  regarded  as 
Allowances  for  Depreciation.  The  word  "allowance"  ex- 
actly expresses  the  status  of  the  account.  A  Reserve  for 
Depreciation,  as  ordinarily  set  up,  has  the  effect  of  indi- 
cating a  false  (inflated)  value  or  amount  of  assets.  This 


INVESTED  CAPITAL  ACCOUNTING  131 

will  be  evident  to  you  if  you  will  carefully  compare  the 
two  Balance  Sheets  that  follow: 

Assets  Liabilities  and  Capital 

Cash $300,000    Notes  Payable $100,000 

Buildings 80,000    Capital    Stock 500,000 

Sundry  Assets 520,000   Reserve  for  Depreciation    10,000 

Surplus   290,000 


$900,000  $900,000 


The  impression  conveyed  to  the  average  person,  by 
the  above  Balance  Sheet,  is  that  the  assets  are  worth  $900,- 
000.  This  is  an  erroneous  conception.  This  Balance  Sheet 
does  not  present  a  correct  statement  of  value.  There  is 
nothing  to  show  that  the  Reserve  for  Depreciation  is  not 
a  true  reserve  for  contingent  (functional)  depreciation, 
while,  as  a  matter  of  fact,  in  this,  as  well  as  in  a  vast 
majority  of  Balance  Sheets,  it  is  intended  to  reflect  actual, 
sustained  depreciation  of  past  time.  See  Articles  844 
and  840  (1). 

A  Better  Way  to  Set  up  the  preceding  Balance  Sheet: 

Assets  Liabilities  and  Capital 

Cash $300,000    Notes  Payable $100,000 

Buildings $80,000  Capital  Stock 500,000 

Less     allowance  Surplus  290,000 

for  Deprecia- 
tion     10,000        70,000 


Sundry  Assets 520,000 


$890,000  $890,000 


In  this  Balance  Sheet  the  assets  appear  at  their  true 
value — $890,000.  Some  might  prefer  to  carry  the  buildings 
at  $80,000  with  an  offsetting  account  of  $10,000  on  the 
liabilities  side,  under  the  name  of  Allowance  for  Depre- 


132  INVESTED  CAPITAL  ACCOUNTING 

elation,  which  would,  of  course,  be  an  equally  true  Balance 
Sheet,  but  the  best  accountants  do  not  do  so  for  the  reason 
that  the  less  mental  effort  required  to  ascertain  the  true 
value  of  any  account  shown  on  a  balance  sheet  the  more 
nearly  is  perfection  attained  in  balance  sheet  construction. 

By  way  of  diversion  from  our  main  topic,  we  will  illus- 
trate this  point.  Look  at  Balance  Sheet  No.  1  and  com- 
pute the  true  (assuming  that  the  "Allowances"  are  exact) 
value  of  Accounts  Receivable  and  of  Machinery. 

Balance  Sheet  No.  1 

Cash   $10,000.10   Accounts   Payable $35,646.00 

Accounts  Receivable . . .  27,427.90    Allowance     for     Bad 

Machinery   149,450.00       Debts    548.56 

Sundry  Assets 76,858.00   Allowance    for    Depre- 
ciation      37,427.00 

Capital  Stock 100,000.00 

Surplus 90,114.44 


$263,736.00  $263,736.00 


Now  look  at  Balance  Sheet  No.  2  and  note  how  much 
easier  it  is  to  ascertain  the  true  values  of  the  same  accounts. 

Balance  Sheet  No.  2 

Cash    $10,000.10   Accounts   Payable $35,646.00 

Account   Re-  Capital  Stock 100,000.00 

ceivable.  .$27,427.90  Surplus    90,114.44 

Less  Allow- 
ance for 
Bad  Debts  548.56-  26,879.34 

Machinery  $149,450.00 

Less    Allow- 
ance   for 
Deprecia- 
tion    37,427.00  112,023.00 

Sundry  Assets 76,858.00 


$225,760.44  $225,760.44 


INVESTED  CAPITAL  ACCOUNTING  133 

Other  So-Called  Reserves 

It  is  not  possible  to  enumerate  all  of  the  so-called 
reserves,  but  usual  ones  are — 

Reserve  for  Unpaid  Wages, 
Reserve  for  Taxes  (unpaid), 
Reserve  for  Accrued  Interest. 
Reserve  for  Salaries, 
Reserve  for  Depletion, 
Reserve  for  Depreciation. 

The  first  four  of  the  above  are  liability  reserves  and 
should  be  accorded  the  same  status  as  Accounts  Payable. 
They  are,  in  effect,  so  far  as  invested  capital  is  concerned, 
at  least,  the  equivalent  of  borrowed  money.  The  last  two 
are  Valuation  Accounts,  sometimes  called  Negative,  or, 
Suspended-Credit  Reserves. 

None  of  these,  nor  any  similar  item  can  be  included  in 
invested  capital,  except  Reserve  for  Federal  Taxes,  and 
this  Reserve  can  be  included  only  up  to  the  date  or  dates 
that  the  taxes  become  due  and  payable. 

If  all  of  such  "reserves"  were  termed  "allowances," 
as  they  should  be,  one's  mind  would  be  less  hazy  and  be- 
wildered on  the  subject  of  what  should  be  included  in,  or 
excluded  from,  invested  capital.  But  since  bookkeepers 
seem  disposed  to  designate  many  a  thing  a  "reserve"  for 
lack  of  knowing  a  better  name,  we  must  accept  things  as 
they  are  and  deal  with  them  accordingly.  It  is  not  the 
writer's  part,  here,  at  least,  to  educate  the  bookkeepers  of 
the  country  in  the  better  way. 

Some  might  insist  upon  calling  the  first  four  given 
above  "accruals."  It  is  true  that  they  do  represent  accrued 
liabilities,  but  it  also  is  true  that  when  any  such  an  account 


134  INVESTED  CAPITAL  ACCOUNTING 

is  set  up,  it  represents  an  amount  allowed  to  take  care 
of  the  liability,  and,  therefore,  may  very  properly  be  termed 
an  allowance;  but  observe  that  the  moment  the  liability 
is  paid,  some  asset  is  reduced  by  an  equal  amount,  while 
in  the  event  of  the  extinguishment  of  a  true  reserve,  the 
amount  of  assets  remains  unchanged. 

One  Intelligible  Sign-Board 

There  is  at  least  one  sure  thing  upon  which  you  can 
depend  when  considering  whether  or  not  any  given  reserve 
should  be  included  in  invested  capital,  and  that  is  this : 

(a)  If  the   account  represents  a  determined,  or  de- 
terminable,  liability,  as  at  the  last  day  of  the 
preceding  accounting  period,  then  it  constitutes  no 
part  of  Surplus ;  neither  is  it  invested  capital ;  it  is 
only  the  equivalent  of  borrowed  money — and  bor- 
rowed money  in  any  form  can  not  be  regarded  as 
a  part  of,  or  as  an  addition  to,  invested  capital. 
See  Article  812. 

(b)  If  the  account  represents  depreciation,  depletion, 
or  any  wasting  away  or  reduction  of  value  desig- 
nated by  a  more  or  less  analogous  term,  it  forms 
no  part  of  invested  capital.    As  before  stated,  such 
accounts  are  sometimes  classified  as  Negative  Re- 
serves, or  Suspended-Credit  Reserves. 

There  is  a  possible  exception  to  the  statement  that 
none  of  the  above  reserves  (so-called)  may  be  included  in 
invested  capital.  If  the  officers  of  a  corporation  decide  to 
leave  their  salaries  in  the  business,  but  are  to  be  paid 
interest  on  the  money,  and  if  their  claim  for  payment  of 
the  amounts  left  in  the  business  would  take  priority  to,  or 
be  on  an  equality  with,  other  creditors,  then  a  Reserve  set 
up  covering  the  amount  of  the  money  left  in  the  business 
by  the  officers  can  constitute  no  part  of  invested  capital. 


INVESTED  CAPITAL  ACCOUNTING  135 

If,  however,  the  officers'  claim  for  payment  would  not 
take  precedence  over  other  creditors,  or  be  on  a  par  with 
the  general  creditors,  then  such  a  Reserve  could  properly 
be  made  a  part  of  invested  capital.  Study  Article  813  very 
carefully.  Also,  Article  814. 

An  Exceptional  Treatment 

Some  financial  institutions,  such  as  banks  and  insurance 
companies,  use  the  term  "reserve"  in  a  manner  altogether 
different  from  the  common  practice  of  commercial  book- 
keepers and  public  accountants,  in  that  the  term  is  found 
on  the  asset  side  of  their  balance  sheets.  As  used  by  them, 
trie  term  has  no  connection  whatever  with  surplus,  profits, 
or,  in  fact,  with  any  specific  item.  What  it  actually  does 
mt^n  in  such  balance  sheets  is  cash,  or  the  equivalent  of 
cash  in  liquid  assets. 

An  Exceptional  Reserve 

There  is  one  reserve,  which,  technically  speaking,  is 
not  a  true  reserve,  that  may  be  included  in  invested  cap- 
ital. This  is  the  account,  Reserve  for  Bad  Debts.  It  may, 
conceivably,  be  a  true  reserve,  and  it  may  not.  It  may 
be  a  Negative,  or  Suspended-Credit  Reserve.  All  of  the 
Accounts  Receivable  and  (or)  Notes  Receivable  may  be 
collectible,  or  collected,  but  the  probabilities  are  that  some 
of  them  will  prove  to  be  worthless,  or  partly  so.  But  for 
income  and  profits  tax  purposes,  the  fact  that  the  Reserve 
is,  doubtless,  a  Valuation  Account,  is  ignored  and  it  is  in- 
cluded in  invested  capital,  unless,  of  course,  the  Reserve 
covers  accounts  or  claims  that  should  have  been  written 
off  the  books  during  a  previous  or  previous  periods. 

Another  Guide  Post 

Another  test  as  to  whether  or  not  a  reserve,  real  or 
so-called,  should  be  included  in  invested  capital:  If  the 


136  INVESTED  CAPITAL  ACCOUNTING 

account  is  of  such  a  nature  that  the  corporation  may  right- 
fully deduct  the  amount  from  gross  income  in  arriving  at 
the  amount  of  net  taxable  income,  then  it  can  not  be  in- 
cluded in  invested  capital.  A  law  of  physics  tells  us  that 
no  one  thing  can  be  in  two  places  at  the  same  moment. 
This  law  can  be  made  to  apply  here  in  this  way — an  account 
can  not  be  placed  among  deductible  items,  and,  at  the  same 
time,  be  included  in  invested  capital.  If  it  is  a  deductible 
item,  it  is  not  invested  capital ;  if  it  is  not  a  deductible  item, 
then  it  is  invested  capital. 

In  the  chapter  on  Depreciation,  Depletion  and  Obsoles- 
cence, you  will  be  advised  as  to  the  only  exception  to  the 
application  of  this  rule,  which  can  happen  only  in  the  case 
of  a  corporation  taking  depreciation  on  the  value  of  an 
asset  as  at  March  1, 1913. 

Contingent  Reserves  are  Invested  Capital 

Any  contingent  reserve,  that  is,  any  reserve  set  up 
as  an  offset  to  something  that  may  or  may  not  transpire 
in  the  future,  should  be  included  in  the  computation  of 
invested  capital.  The  usual  reserves  of  this  class  are — 

Reserve  for  Improvements  (possibly), 
Reserve  for  Rebates, 
Reserve  for  Guarantees, 
Reserve  for  Discount, 
Reserve  for  Accidents, 

Reserve  for  Employees'  Liability  Insurance,  Damaged 
Crops,  and  similar  potentialities, 

and,  in  addition,  the  general,  all-embracing  reserve,  Reserve 
for  Contingencies,  which  may  include  any  or  all  of  the 
above,  as  well  as  many  others. 


INVESTED  CAPITAL  ACCOUNTING  137 

Specific  Reserves 

There  is  another  class  of  reserves  that  deserve  men- 
tion— the  Specific  Reserves — that  should  not  be  embraced 
under  the  classification  of  "Contingent  Reserves,"  although 
there  are  conditions  under  which  some  of  them  could  prop- 
erly be  so  classified.  If  a  concern  has  definitely  determined 
to  extend  its  plant,  a  reserve  set  up  for  that  purpose  is 
not  a  contingency,  but  is  an  actuality.  Such  reserves  as — 

Reserve  for  Plant  Extension, 
Reserve  for  Bond  Redemption, 
Reserve  for  Amortization  of  Good  Will, 
Reserve  for  Improvements  (possibly), 

and  all  similar  reserves  are  of  this  class  and  are  a  part  of 
invested  capital.  In  fact,  any  true  reserve  that  is  properly 
a  direct  charge  to  Surplus  must  be  included  in  invested 
capital. 

One  other  possibly  contingent  reserve  will  be  found 
occasionally — Reserve  for  Redemption  of  Coupons.  No  posi- 
tive dictum  can  be  given  on  this.  The  author  would,  should 
he  be  auditing  a  case  containing  such  a  reserve,  ascertain 
the  past  experience  of  the  concern  as  to  what  percentage 
of  such  an  account  is  an  actual  liability  and  would  allow 
as  invested  capital  the  difference  between  the  amount  of 
the  ascertained  liability  and  the  amount  set  up  in  the  re- 
serve. It  is  conceivable  that  analogous  procedure  should 
be  followed  in  Reserve  for  Guarantees,  such  as  we  get  with 
Hole-Proof  Hosiery,  or  Reserve  for  Rebates,  as  where  a 
rebate  may  be  allowed  each  purchaser  contingent  on  a  les- 
sening of  selling  price  by  reason  of  quantity  production, 
as  was  done  at  least  once  by  the  Ford  Motor  Company. 
In  any  of  such  cases  the  auditor  must  exercise  careful  judg- 
ment and  obtain  all  the  data  possible  that  apply  to  the  case 


138  INVESTED  CAPITAL  ACCOUNTING 

and  base  his  conclusions  solely  on  the  information  bearing 
on  the  instant  case  and  not  on  any  generalities,  for  in  cases 
involving  possible  contingent  liabilities  generalities  can  not 
be  accepted  as  guides. 

Fix  firmly  in  your  mind  this  fact:  A  true  reserve  is 
allocated  Surplus  and  nothing  else.  At  any  time  the  board 
of  directors  may  wipe  out  the  Reserve  and  throw  it  back 
into  Surplus,  thereby  making  it  available  for  dividends, 
or  for  any  other  purpose  they  may  decide  upon.  The  reason 
for  setting  up  such  a  reserve  is  to  "tag"  a  certain  portion 
of  Surplus  for  some  definite  object  to  fhe  end  that  it  may 
not  be  easily  available  for  dividends,  or  to  keep  grasping 
stockholders  from  demanding  larger  dividends  than  are 
being  declared ;  a  scheme  to  "pull  the  wool  over  the  stock- 
holders' eyes." 

Reserve  for  Insurance 

Some  concerns,  having  plants  or  buildings  at  different 
localities,  carry  their  own  fire  insurance;  that  is,  they 
set  up  a  Reserve  for  Insurance,  charging  it  to  Surplus, 
and,  in  case  of  loss  by  fire  charge  the  loss  to  the  Reserve. 

The  status  of  this  Reserve  is  as  difficult  to  define  as 
is  the  status  of  Reserve  for  Bad  Debts,  and  it  occupies  a 
position  very  similar  to  the  position  of  the  latter  in  that 
it  may  be  a  true  reserve,  or  a  portion  (and,  perhaps,  all) 
of  it  may  be  a  Suspended-Credit  Reserve.  To  the  extent 
that  it  represents  a  true  reserve  (which  can  be  determined 
only  by  an  examination  of  the  books  of  the  corporation), 
it  should  be  included  in  invested  capital. 

Funds 

Hold  fast  to  the  fact  that  funds  are  assets,  and  that 
reserves  are  found  on  the  other  side  of  the  Balance  Sheet, 
frequently  as  contra  entries  to  funds.  Note  the  location  of 
the  various  items  on  the — 


INVESTED  CAPITAL  ACCOUNTING  139 

BALANCE  SHEET 

Assets  Liabilities  and  Capital 

Funds  Reserves 

Sinking  Fund  Allowances 

Reserve  Funds  Funded  Reserves 


If  you  have  been  studying  any  books  on  accounting 
that  place  any  of  the  above  on  the  side  of  the  balance  sheet 
the  reverse  from  what  is  here  given,  do  not  continue  to 
be  misled.  The  above  distribution  of  these  accounts  is  abso- 
lutely correct,  and  the  only  correct  distribution,  eminent 
authors  to  the  contrary,  notwithstanding.  Dicksee,  in  his 
work,  "Good  Will  and  Its  Treatment  in  Accounts,"  presents 
(on  page  129,  third  edition)  Reserve  Fund  as  a  liability 
item  on  the  balance  sheet.  It  should  be  interesting  to  know 
if  he  would  place  the  contra  account,  Funded  Reserve,  among 
the  assets ! 

Double  Use  of  the  Term  "Sinking  Fund" 

It  should  be  noted  that  some  concerns,  especially  trans- 
portation lines,  occasionally  carry  Sinking  Fund  both  as 
an  asset  and  as  a  liability,  as — 


Assets  Liabilities  and  Capital 

Cost  of  Construction. $59,400,000   Capital  Stock $30,000,000 

Cash  in  Hand  of  Sink-  Funded    Debt 30,000,000 

ing  Fund  Trustee..        300,000    Sinking  Fund 300,000 

Cash   900,000   Balance  of  Income  Ac- 
count            300,000 


$60,600,000  $60,600,000 

This  is  unusual  treatment.    If  the  word  "reserve"  fol- 


140  INVESTED  CAPITAL  ACCOUNTING 

lowed  "sinking  fund"  on  the  liabilities  side,  the  apparent 
contrariety  would  disappear,  and  the  Balance  Sheet  would 
fairly  indicate,  as  it  should,  that  the  amount,  $300,000,  is 
Appropriated  Surplus  and  that  it  should  be  included  in  the 
computation  of  invested  capital. 

Balance  Sheet  Examples  of  the  Use  of  Terms 

The  following  illustrations  of  the  different  ways  of 
indicating  values,  and  Surplus  and  Reserves,  will  impress 
on  your  mind  the  fact  that  calling  "cash"  by  other  names 
does  not  affect  its  status.  For  pedagogical  reasons  no 
attention  is  paid  to  arranging  the  items  in  true  technical 
sequence. 


Assets  Liabilities  and  Capital 

Cash    $300,000   Notes  Payable $100,000 

Accounts    Receivable 150,000   Capital  Stock 500,000 

Sundry  Assets 450,000   Surplus    300,000 


$900,000  $900,000 


No  statutory  adjustments  entering  into  this  proposi- 
tion, the  invested  capital  is  $800,000;  that  is,  Capital  Stock 
plus  Surplus.  See  Article  831. 

Now  let  us  assume  that  instead  of  Notes  Payable,  the 
corporation  had  issued  bonds  to  the  amount  of  $100,000 
in  January,  1917,  payable  in  ten  years,  and  that  it  was 
stipulated  (as  is  usual)  in  the  contract  with  the  purchaser 
of  the  bonds  that  out  of  the  profits  of  each  of  the  ten  sub- 
sequent years,  there  was  to  be  placed  in  the  hands  of  a 
trustee  $10,000  as  a  Reserve  Fund  (disregarding,  for  the 
moment,  the  compounding  of  interest)  to  take  care  of  the 
bonds  at  maturity.  This  fund  might  be  called  simply 


INVESTED  CAPITAL  ACCOUNTING  141 

Fund,  or  it  might  be  called  Reserve  Fund,  Sinking  Fund, 
Bond  Redemption  Fund,  or  by  any  other  name  that  should 
indicate  its  function.  At  January  1, 1918,  the  Balance  Sheet 
might  appear  as  follows : 


Assets  Liabilities  and  Capital 

Cash $290,000  First  Mortgage  Bonds. .  .$100,000 

Reserve   Fund 10,000  Capital    Stock 500,000 

Accounts    Receivable 150,000  Surplus   300,000 

Sundry    Assets 450,000 


$900,000  $900,000 


The  invested  capital  is  still  $800,000.  You  will  see 
by  this  that  a  reserve  fund  does  not  affect  invested  capital 
— it  simply  changes  the  account,  Cash,  into  two  accounts; 
Cash  Account,  and  Reserve  Fund  Account.  Of  course,  you 
know  that  Funds  mean  Money  and  that  Money  Means  Cash ; 
hence,  Funds  usually  mean  Cash.  For  that  matter,  the 
word  "cash"  need  not  appear  on  a  balance  sheet.  "Funds" 
is  equally  appropriated. 

It  might  be,  although  it  would  be,  perhaps,  unusual, 
that  the  Fund  would  be  created  out  of  some  liquid  asset 
other  than  Cash,  as,  for  instance,  out  of  Securities.  In 
such  an  event,  Securities  Account  would  be  the  account 
that  would  be  divided  into  two  accounts  (provided  the  con- 
cern held  more  securities  than  the  amount  of  the  Fund) 
instead  of  Cash  Account. 

Now  assume  that  the  corporation  contemplates  the 
erection  of  a  building  (or  some  other  improvement,  as  the 
purchase  at  a  future  date  of  new  machinery,  additions  to 
present  buildings,  the  installation  of  a  sprinkler  system, 
or,  etc.).  It  is  felt  that  it  would  be  wise  to  make  certain 
that  too  much  will  not  be  declared  out  as  dividends  and 


142  INVESTED  CAPITAL  ACCOUNTING 

it  is  decided  to  set  up  a  reserve  for  this  purpose.    The  Bal- 
ance Sheet  might  then  appear  as  follows : 


Assets  Liabilities  and  Capital 

Cash $290,000  First  Mortgage  Bonds . .  $100,000 

Reserve   Fund 10,000  Capital    Stock 500,000 

Accounts    Receivable 150,000  Reserve  for  Building...   100,000 

Sundry    Assets 450,000  Surplus   200,000 


$900,000  $900,000 


The  amount  of  invested  capital  has  not  changed;  it 
is  still  $800,000.  At  any  day  the  Directors  may  decide 
not  to  build  and  may  vote  to  restore  the  Reserve  to  Surplus 
— it  IS  Surplus  under  another  name,  just  the  same  as  Funds 
is  Cash  under  another  name.  But,  even  though  the  cor- 
poration goes  ahead  and  erects  the  building,  invested  cap- 
ital is  not  affected.  The  Balance  Sheet,  after  the  building 
is  built,  might  appear  as  follows : 


Assets  Liabilities  and  Capital 

Cash $190,000  First  Mortgage  Bonds. .  .$100,000 

Reserve   Fund 10,000  Capital    Stock 500,000 

Accounts    Receivable 150,000  Surplus   300,000 

Building    100,000 

Sundry  Assets 450,000 


$900,000  $900,000 


The  following  journal  entries  would  probably  have 
been  made  to  bring  about  the  status  of  the  accounts  as 
reflected  on  the  above  Balance  Sheet: 


INVESTED  CAPITAL  ACCOUNTING  '143 

Building   $100,000 

Cash   $100,000 

(Explanation) 

Reserve  for  Building $100,000 

Surplus    $100,000 

(Explanation) 


No  change  has  taken  place  in  the  amount  of  invested 
capital ;  it  is  still  $800,000. 

These  problems,  it  should  be  noted,  are  stated  as  though 
all  these  transactions  took  place  simultaneously.  Of  course, 
if  another  year  has  gone  by,  the  Reserve  Fund  in  the  above* 
Balance  Sheet  should  be  $20,000,  instead  of  $10,000,  and 
Cash  would  be  $10,000  less,  but  that  makes  no  difference 
in  values,  or  in  invested  capital. 

One  of  the  most  difficult  reserves  properly  to  classify, 
is  Reserve  for  Bad  Debts.  As  previously  noted,  it  may  be 
a  true  reserve  and  it  may  not.  Had  the  above-mentioned 
corporation  set  up  a  Reserve  for  Bad  Debts,  the  Balance 
Sheet  might  appear  thus: 


Assets  Liabilities  and  Capital 

Cash    $190,000  First  Mortgage  Bonds . .  $100,000 

Reserve   Fund 10,000  Reserve  for  Bad  Debts ..     15,000 

Accounts    Receivable 150,000  Capital    Stock 500,000 

Building    100,000  Surplus   285,000 

Sundry    Assets 450,000 


$900,000  $900,000 


It  could  quite  properly  be  set  up  as  shown  below,  which 
will  make  it  clear  to  you  that  this  Reserve,  so  far  as  profits 
taxes  are  concerned,  has  the  precise  status  of  Surplus : 


144  INVESTED  CAPITAL  ACCOUNTING 

Assets  Liabilities  and  Capital 

Cash $190,000    First  Mortgage  Bonds . .  $100,000 

Reserve  Fund 10,000    Capital    Stock 500,000 

Accounts   Receivable 150,000    Surplus: 

Building    100,000       Reserved      (for     Bad 

Sundry  Assets 450,000  Debts)    15,000 

Unreserved    285,000 


$900,000  $900,000 


Funded  Reserves 

Suppose  that  this  corporation  wishes  to  be  certain  of 
having  $75,000  available  cash  on  hand  at  some  time  in  the 
indefinite  future,  or  at  a  definite  future  date.  The  account, 
Cash,  already  has  been  divided  into  two  accounts — Cash 
Account,  and  Reserve  Fund  Account.  It  now  further  sub- 
divides Cash  and  sets  up  a  Special  Reserve  Fund  Account. 
It  also  wishes  to  guard  against  declaring  too  large  a  divi- 
dend, or  it  does  not  wish  the  stockholders  to  know  just 
how  much  could  be  available  for  dividends.  Surplus  can 
be  further  sub-divided  by  setting  up  a  Funded  Reserve,  as 
shown  by  the  following  Balance  Sheet : 


Assets  Liabilities  and  Capital 

Cash    $115,000  First  Mortgage  Bonds . . .  $100,000 

Reserve  Fund 10,000  Reserve  for  Bad  Debts. .     15,000 

Special  Reserve  Fund...  75,000  Funded   Reserve 75,000 

Accounts    Receivable 150,000  Capital    Stock 500,000 

Building    100,000  Surplus   210,000 

Sundry  Assets 450,000 


$900,000  $900,000 


Still  the  invested  capital  is  $800,000.     It  should  be 


INVESTED  CAPITAL  ACCOUNTING  145 

clear  from  a  study  of  this  Balance  Sheet  that  the  term 
"Funded  Reserve"  means  that  funds  have  been  set  aside 
to  the  amount  of  the  Reserve,  and  that  is  all  that  it  does 
mean ;  the  Reserve  is  funded. 

This  Reserve  might  have  been  allowed  to  remain  in 
Surplus,  since  there  is  no  direct  accounting  relationship  be- 
tween any  specific  item  on  the  asset  side  with  any  specific 
item  on  the  liability  side.  Either  can  be  set  up  without  any 
necessity  (from  the  viewpoint  of  accountancy)  for  setting 
up  the  other,  and  either  may  be  eliminated  without  the 
necessity  (technically  speaking)  of  treating  the  other  in  a 
like  manner. 

To  make  the  matter  still  clearer,  Cash  could  be  made 
to  appear  in  the  above  Balance  Sheet  in  this  manner: 


Assets 
Cash: 

Checking  Account $115,000 

With  Trustee 10,000 

Special  Fund 75,000 


$200,000 


The  objection  to  this  way  of  stating  "cash"  is  that 
it  requires  scheduling  a  "current  asset"  with  other  classifi- 
cations of  assets.  The  technician  will  tell  you  that  to  set 
up  Cash  on  a  Balance  Sheet  in  this  manner  is  indefensible, 
and  he  would  be  stating  a  fact.  The  only  reason  for  so 
doing  in  this  case  is  to  impress  on  your  mind  that  to  trans- 
form the  account  Cash,  into  other  asset  accounts,  does  not 
affect  values  in  the  least. 

In  the  preceding  illustrations  you  have  been  shown 
certain  reserves  that  are  to  be  included  in  invested  capital, 
and  you  have  been  told  why  they  are  to  be  included.  The 


146  INVESTED  CAPITAL  ACCOUNTING 

problem  that  follows  illustrates  cases  where  certain  reserves 
(so-called)  may  not  be  included  in  the  determination  of 
invested  capital. 

We  shall  assume  that  the  building  for  which  a  reserve 
had  been  created,  was  erected  in  January,  1914,  and  that 
its  probable  life  at  that  time  was  fifty  years.  In  December, 
1917,  the  corporation  had  a  crew  of  men  engaged  in  Civil 
Engineering  at  a  remote  point,  and  at  December  31,  1917, 
the  report  of  the  foreman  covering  certain  expenses  con- 
nected therewith  had  not  been  received.  The  following 
is  the — 


BALANCE  SHEET 
as  at  December  31,  1917 

Assets  Liabilities  and  Capital 

Cash $115,000  First  Mortgage  Bonds. $100,000 

Reserve  Fund 10,000  Reserve  for  Bad  Debts.     15,000* 

Special  Reserve  Fund . . .     75,000  Reserve    for    Surveying 

Accounts    Receivable 150,000       Expenses   9,000 

Building    100,000  Reserve    for    Deprecia- 

Land    80,000       tion 6,000 

Sundry  Assets 400,000    Capital  Stock 500,000* 

Surplus  300,000* 


$930,000  $930,000 


At  first  glance  one  would  say  that  the  invested  capital 
is  $815,000,  made  up  of  the  items  marked  with  the  asterisk. 
A  closer  inspection  discloses  the  fact  that,  while  the  land 
is  now  actually  worth  $80,000,  the  cost  price  was  $50,000. 
We  find  that  the  building  was  erected  in  January,  1914, 
and  that  it  should  be  depreciated  for  four  years,  at  2% 
per  annum.  Also,  we  find  that  Sundry  Assets,  while  they 


INVESTED  CAPITAL  ACCOUNTING  147 

cost  $400,000,  should  be  reduced  to  $360,000,  that  being 
the  depreciated  value  as  at  December  31,  1917.  It  is  fur- 
ther found  that  Reserve  for  Surveying  Expenses  was  an 
actual  liability  as  at  December  31,  1917,  and  is,  therefore, 
a  Suspended-Credit  Reserve,  and  can  not  be  included  in 
invested  capital.  For  profits  tax  purposes  we  must  recon- 
struct the  Balance  Sheet,  as  follows  (See  Article  831  and 
Article  844,  last  paragraph) : 


Assets  Liabilities  and  Capital 

Cash $115,000   First  Mortgage  Bonds.  .$100,000 

Reserve    Fund 10,000   Reserve  for  Bad  Debts.     15,000* 

Special  Reserve  Fund. . .     75,000   Reserve     for     Surveying 

Accounts    Receivable 150,000       Expense 9,000 

Building    $100,000  Capital    Stock 500,000* 

Less  Allowance  Surplus 228,000* 

for    Deprecia- 
tion          8,000     92,000 

Land 50,000 

Sundry  Assets .  $400,000 
Less     Deprecia- 
tion        40,000     360,000 


$852,000  $852,000 


It  should  be  evident  from  the  above  illustration  that 
the  invested  capital  is  $743,000.  See  Article  836,  lines  10, 
11  and  12. 

Had  Reserve  for  Surveying  been  set  up  to  cover  future 
operations,  it  should  be  included  in  invested  capital.  Or 
were  these  expenditures  such  as  should  be  capitalized  then 
they  should  be  included  in  invested  capital,  in  which  event 
they  would  not  constitute  an  allowable  deduction  from  gross 
income. 


148  INVESTED  CAPITAL  ACCOUNTING 

Secret  or  Hidden  Reserves 

At  the  present  time,  when  corporations  are  striving 
to  show  as  large  an  invested  capital  as  possible,  we  are 
not  likely  to  be  much  troubled  with  secret  reserves,  de- 
liberately created  by  a  corporation. 

However,  many  a  corporation  creates,  in  effect,  a  secret 
reserve  unconsciously.  Where  too  much  depreciation  is 
charged  off,  or  where  capital  expenditures  are  charged  to 
Expense,  hidden  reserves  are  created. 

In  the  matter  of  the  Z-Y  Corporation  it  was  found  that 
it  had  depreciated  its  plant  by  $165,000,  whereas  the  actual 
depreciation  was  only  $92,000.  Also,  it  had  charged  to 
Expense,  not  only  the  engineer's  plans  and  specifications 
for  the  location  of  some  new  machines  in  its  plant,  but 
the  machines  had  been  charged  to  Expense.  The  total  thus 
charged  to  expense  was  $8,350,  consequently  the  assets 
were  understated  by  $81,350,  which  is  equivalent  to  a  secret 
or  hidden  reserve,  and  should  be  reflected  in  Surplus,  thereby 
increasing  the  invested  capital  of  the  concern,  and,  of 
course,  increasing  the  taxable  net  income  of  previous 
periods  by  a  like  amount. 

Allowance  for  Doubtful  Accounts  Must  Be  Included 

Occasionally  you  will  find  a  Balance  Sheet  set  up  similar 
to  the  following: 

Assets  Liabilities  and  Capital 

Cash    $100,000   Notes  Payable $80,000 

Accounts    Receiv-  Capital    Stock 200,000 

able $20,000  Surplus   139,600 

Less    2  %    for 

Doubtful     A  c  - 

counts 400     19,600 

Sundry    Assets.... 300,000 


$419,600  $419,600 


INVESTED  CAPITAL  ACCOUNTING  149 

A  hasty  glance  at  the  above  would  indicate  that  the 
invested  capital  should  be  $339,600.  This  is  not  correct. 
It  should  be  plain  to  you  that  had  Accounts  Receivable 
been  set  up  on  the  Balance  Sheet  at  the  total  of  $20,000 
and  an  Allowance  for  Doubtful  Accounts,  amounting  to  $400, 
shown  on  the  liabilities  side,  it  would  then  be  evident  that 
the  invested  capital  would  be,  Capital  Stock,  $200,000 ;  plus 
Allowance  for  Doubtful  Accounts,  $400;  plus  Surplus, 
$139,600,  giving  a  total  invested  capital  amounting  to 
$340,000,  for,  as  you  were  previously  told,  the  Allowance  for 
Doubtful  Accounts  is  included  in  invested  capital,  and  if  it 
should  appear  set  up  as  above,  the  Allowance  amount  de- 
ducted from  the  total  of  Receivables  must  be  added  to  Sur- 
plus in  computing  invested  capital. 

An  Anomaly 

Why  have  an  account  termed  either  "Reserve  for 
Bad  Debts"  (all  will  agree  that  this  expression  is  quite 
common)  or  "Allowance  for  Bad  Debts?"  If  the  debt  is 
"bad" — worthless — it  should  be  charged  off,  and  there  would 
be  no  call  for  any  such  account.  The  only  truly  descriptive 
title  is  "Allowance  for  Doubtful  Accounts."  A  doubtful 
account  may  be  collected ;  a  "bad"  account  never  is. 

It  may  be  asked  why  I  do  not,  in  all  cases,  adhere  to 
the  terms  recommended.  Simply  this:  It  is  wished  to  pre- 
sent to  you  balance  sheets  such  as  are  found  in  taxpayers' 
returns  to  show  you  the  work  as  it  is  presented  to  us ;  not 
as  we  would  have  it  appear. 

Things  to  Remember 

Every  item  on  the  asset  side  must  first  be  adjusted 
to  its  true  value  based  on  its  original  cost,  less  any  depre- 
ciation since  the  time  of  its  acquisition,  and  that  every 
time  any  such  adjustment  is  made,  a  like  adjustment  must 
be  made  to  Surplus. 


150  INVESTED  CAPITAL  ACCOUNTING 

Appreciation  of  values,  no  matter  how  real  or  actual 
it  may  be,  is  not  admitted  in  computing  invested  capital. 

The  reserves  that  may  be  included  in  invested  capital 
are  the  Specific  Reserves  and  reserves  that  have  been  set 
up  to  offset  future  contingencies.  No  other  reserve  may 
be  included  in  invested  capital. 

If  there  is  an  account,  Undivided  Profits,  it  must  be 
examined  just  as  closely  as  the  Surplus  Account.  If  such 
an  account  is  on  the  Balance  Sheet,  and  sufficient  depre- 
ciation has  not  been  charged  to  Profit  and  Loss  or  if  earn- 
ings (so-called)  are  the  result  of  enhanced  values,  and 
these  earnings  have  been  entered  as  a  credit  to  Undivided 
Profits  (or  to  Surplus),  Undivided  Profits  (or  Surplus)  must 
be  reduced  by  the  amount  of  inflation.  Study  Articles  162, 
164,  165,  and  169. 


CHAPTER  NINE 
TANGIBLE  PROPERTY— INTANGIBLE  PROPERTY 

All  corporate  property  must  be  classed  either  as  tan- 
gible property  or  as  intangible  property. 

The  income  tax  definition  of  these  two  terms  is  not 
in  complete  harmony  with  the  Websterian  definition,  in 
that  Webster  defines  "tangible"  as,  "capable  of  being 
touched,  possessed,  etc.,"  and,  of  course,  "intangible"  is 
defined  as  being  the  exact  opposite  of  "tangible." 

All  intangible  property  is  "capable  of  being  possessed," 
and  some  tangible  property  is  not  "capable  of  being 
touched."  Certain  it  is  that  a  patent  or  a  copyright  is 
just  as  "tangible"  as  are  accounts  and  notes  receivable,  in 
so  far  as  the  dictionary  definition  applies. 

It  seems  to  the  author  that  the  adoption  of  the  terms 
"tangible"  and  "intangible"  was  unfortunate — the  result 
often  being  mental  confusion  on  the  part  of  the  auditor. 
If  the  terms  "tangible-value  property"  and  "intangible-value 
property"  had  been  adopted  the  matter  would  have  appeared 
much  clearer  in  the  mind  of  the  average  auditor,  for  those 
terms  precisely  express  what  is  meant.  We  can  "see"  the 
value  in  a  ton  of  steel  rails,  or  in  a  carload  of  coal,  but 
the  value  of  a  copyright  or  of  a  trade-mark  is  not  so 
evident. 

That  the  terms  just  named  are  really  appropriate  is 
proved  by  the  fact  that  any  of  the  properties  classified  by 
law  and  regulations  as  intangible  lose  their  tangible  aspect 
the  moment  they  are  acquired  by  a  corporation  for  cash 


152  INVESTED  CAPITAL  ACCOUNTING 

or  in  any  manner  other  than  by  the  issuance  of  stock  or 
shares  of  the  acquiring  corporation;  in  other  words,  the 
value  in  such  cases  can  be  "seen"  and  such  property,  for 
invested  capital  purposes  has  become  tangible,  although  the 
property  itself  is  just  as  intangible  as  it  was  previously. 

Since  it  is  easier  to  specify  the  kinds  of  property  that 
are  classified  as  intangible  than  it  is  to  name  the  various 
properties  that  are  classified  as  tangible,  there  is  given 
below  a  list  of  the  chief  intangibles: 

Patents,  Goodwill, 

Copyrights,  Secret  Formulae, 

Trade-Marks,  Most  Contracts, 

Trade  Names,  Mailing  Lists, 

Trade-Brands,  Subscription  Lists. 

Associated  and  United  Press  and  similar  Franchises. 

All  property  that  is  not  intangible  must  be  regarded  as 
tangible.  See  Article  811. 

Reason  for  the  Distinction 

Usually,  tangible  property  is  of  such  a  nature  that  a 
definite,  fair  cash  value  can  be  placed  upon  it.  It  is  not 
at  all  difficult  to  ascertain  the  value  of,  let  us  say,  a  thou- 
sand tons  of  pig  iron,  or  of  a  parcel  of  real  estate,  or'  of  a 
building,  or  of  a  piece  of  machinery. 

If  a  corporation  acquires  any  property  of  this  class 
(the  tangible  class)  and  pays  for  it  with  stock  or  shares 
of  the  corporation,  we  can  readily  determine  whether  or 
not  it  gave  stock  in  excess,  on  the  basis  of  the  par  value 
of  the  stock,  of  the  actual  cash  value  of  the  property 
acquired. 

Practically  all  items  of  merchandise,  machinery  of 
every  description,  transportation  equipment,  live  stock, 


INVESTED  CAPITAL  ACCOUNTING  153 

minerals,  timber,  etc.,  have  a  known  or  ascertainable  mar- 
ket value.  If  the  market  value  of  real  estate  can  not  be 
determined,  the  fair  value  can  be  arrived  at  in  other  ways, 
as,  for  examples,  sales  in  the  immediate  vicinity,  bona  fide 
cash  offers  recently  made  (with  reference  to  the  date  of 
acquisition)  for  the  property  or  for  adjoining  property, 
recourse  to  the  city  or  county  assessment  books,  or  by 
reputable  appraisal. 

Observe,  however,  that  none  of  these  methods  should 
be  resorted  to  in  order  to  determine  the  value  of  property 
for  invested  capital  purposes  where  it  has  been  bought  for 
cash,  or  for  the  equivalent  of  cash.  We  have  reference 
only  to  the  ascertainment  of  value  (or  worth)  where  any 
tangible  property  has  been  taken  in  exchange  for  stock 
or  shares  and  where  the  stock  or  shares  have  no  well- 
determined  value.  When  any  property  is  purchased  for 
cash,  the  amount  of  the  cash  paid  sets  the  value,  for  in- 
vested capital  purposes,  and  not  what  may  be  determined 
or  thought  to  be  the  value  of  the  property. 

In  this  connection,  "cash"  may  mean  things  other  than 
money.  Other  property,  if  tangible,  would  be  an  equivalent 
of  cash.  Also,  notes,  or  other  instruments  of  indebtedness 
given  for  the  property,  in  good  faith,  would  be  regarded  as 
the  equivalent  of  cash. 

No  Market  Quotations  on  Intangibles 

On  the  other  hand,  where  can  we  find  a  market  quo- 
tation on  the  value  of  goodwill?  or  on  a  copyright?  or  on 
a  patent  ?  There  are  no  such  standards  upon  which  to  base 
conclusions. 

The  amount  that  the  goodwill  of  Brown,  Davis  &  Co., 
sold  for  has  no  bearing  whatever  on  the  value  of  the  good- 
will of  Smith,  Jones  &  Co.  That  some  patent  earned  a 
million  dollars  for  its  owner  has  no  bearing  in  arriving 


154  INVESTED  CAPITAL  ACCOUNTING 

at  the  value  of  any  other  patent,  even  of  a  patent  on  some- 
thing very  similar,  and,  perhaps,  greatly  improved. 

The  fact  that  the  name  "Kodak"  may  be  valuable  as 
a  trade  name  does  not  indicate  that  any  other  trade  name, 
or  trade-mark,  would  possess  any  value.  In  fact,  the  value 
placed  upon  any  intangible  property,  whether  paid  for  in 
cash  or  in  stock,  is  only  a  guess  at  best,  based  (usually)  on 
the  income  that  the  intangible  may  have  possibly  earned 
in  the  past,  and  the  hope  that  it  will  continue  to  be  equally 
productive  of  profit  in  the  future. 

If  Jones  buys  a  carload  of  wheat  and  pays  $3  a  bushel 
for  it,  and  $3  is  its  market  value,  then  that  is  the  value 
of  Brown's  or  of  Smith's  wheat,  due  to  the  fact  that  their 
wheat  will  produce  practically  the  same  amount  of  flour 
as  may  be  obtained  from  Jones'  wheat — it  possesses  pre- 
cisely the  same  economic  value. 

That  the  copyrights  to  Longfellow's  poems  were  ex- 
tremely valuable  to  their  owners  does  not  set  any  value 
on  a  copyright  on  "Poems  by  Shortfellow."  There  is  no 
analogy  between  the  method  of  arriving  at  the  value  of 
Brown's  wheat  and  the  value  of  Shortfellow's  copyright. 
We  know  just  what  the  wheat  will  produce;  we  do  not  know 
that  the  copyright  will  earn  even  the  dollar  that  it  cost  to 
procure  it. 

Now  if  Shortfellow  sells  his  copyright  to  Cohn  for 
$10,000  cash,  the  sale  establishes  Cohn's  invested  capital 
in  the  copyright  at  $10,000,  the  presumption  being  that 
he  would  not  part  with  that  amount  of  cash  in  exchange 
for  the  copyright  unless  he  could  see,  or  thought  he  could 
see,  that  value  in  it.  Whether  or  not  that  value  is  there 
is  not  open  to  question ;  he  was  willing  to  part  with  §10,000 
for  it,  hence  his  invested  capital  in  this  intangible  is  the 
amount  he  put  in  it — it  now  is  tangible-value  property  to 
the  extent  of  $10,000. 


INVESTED  CAPITAL  ACCOUNTING  165 

Shortfellow,  being  so  successful  with  this  copyright 
on  his  authorship,  gets  out  another  book,  "The  Joys  and 
Pleasures  of  a  Revenue  Agent/'  and,  of  course,  another 
copyright.  The  fact  that  he  received  $10,000  for  the  first 
copyright  does  not  operate  to  set  a  value — big  or  little — 
on  the  second  copyright.  It  may  be  worth  nothing — it 
may  be  worth  a  million,  but  whether  it  be  worth  more  or 
less  is  purely  problematic.  Of  course,  once  an  author  scores 
a  success,  it  is  generally  conceded  that  the  public  will  wish 
to  read  his  subsequent  works,  but  that  is  only  presump- 
tion and  has  no  weight  in  so  far  as  income  tax  is  being 
determined. 

If  Brown  gets  $3  for  one  bushel  of  his  wheat,  the  other 
bushels  in  his  granary  or  elevator  are  reasonably  presumed 
to  be  worth  $3  each,  because  they  will  produce  exactly  the 
same  results  as  did  the  first  bushel.  If  a  corporation  issued 
$30,000,  par  value,  worth  of  stock  for  10,000  bushels  of 
Brown's  wheat,  and  $3  was  the  market  value,  we  would 
admit  that  the  stock  brought  par  value  to  the  corporation. 

Now  this  gives  us  the  key  to  the  reason  for  valuing 
tangible  property  and  intangible  property  upon  entirely 
different  bases.  In  the  case  of  tangibles,  the  true  value 
almost  always  is  determined  or  capable  of  determination, 
while  in  the  case  of  intangibles,  any  value  placed  upon  them 
is  only  hypothetical  at  best — a  pure  guess,  unless  they  be 
sold  (or  purchased)  for  cash — and  that  is  another  matter, 
to  be  told  later. 

When  tangible  property  is  acquired  in  exchange  for 
stock  or  shares  we  can  usually  determine  the  actual  value 
that  the  stock  or  shares  contributed  to  the  business.  When 
intangible  property  is  acquired  for  stock  or  shares  we  can 
allow  only  on  a  percentage  basis  the  amount  to  be  reflected 
in  invested  capital.  The  rate  of  percentage  used  is  purely 
arbitrary,  but,  inasmuch  as  it  is  impossible  to  arrive  at 
an  exact,  or  even  an  approximate  value,  this  is  the  only 


156  INVESTED  CAPITAL  ACCOUNTING 

feasible  way  out  of  the  dilemma  of  placing  a  value,  for  in- 
vested capital  purchases,  on  intangible  property. 

Tangible  Property  Paid  in  for  Stock  or  Shares 

Where  tangible  property  has  been  paid  in  for  stock 
or  shares,  it  is  valued  at  its  actual  cash  value  at  the  time 
it  was  acquired  by  the  concern.  If  this  value  be  less  than 
the  par  value  of  the  stock  or  shares  issued  therefor,  the 
amount  to  be  allowed  as  a  basis  of  invested  capital  is  the 
cash  value  of  the  property,  and  not  the  par  value  of  the 
stock  or  shares  issued  for  it. 

Similarly,  if  the  property,  at  the  time  it  was  paid  in, 
had  an  actual  cash  value  over  and  above  the  par  value  of 
the  stock  or  shares  issued  therefor,  the  corporation  may 
set  up  a  Paid-in  Surplus  reflecting  the  difference  between 
the  par  value  of  the  stock  or  shares  and  the  actual  cash 
value  of  the  tangible  property  for  which  the  stock  or  shares 
were  issued.  See  Article  836. 

Intangible  Property  Paid  in  for  Stock  or  Shares 

Where  intangible  property  has  been  paid  in  for  stock 
or  shares,  the  procedure  relative  to  ascertaining  the  value 
thereof  is  much  different  from  the  course  followed  with 
respect  to  tangible  property  paid  in  for  stock  or  shares. 

No  matter  how  much  may  be  its  presumptive  actual 
cash  value,  the  amount  allowable  as  a  basis  for  invested 
capital  is  rigidly  established  on  a  percentage  basis  thus — 

Paid  in  Prior  to  March  3,  1917 

If  intangible  property  is  paid  in  for  stock  or  shares 
prior  to  March  3,  1917,  the  amount  that  may  be  included 
in  invested  capital  must  not  exceed — 


INVESTED  CAPITAL  ACCOUNTING  157 

(a)  The  actual  cash  value  of  the  (intangible)  property  paid  in. 
Assume  that  a  corporation  issued  $50,000,  par  value  stock 
for  good  will  (or  other  intangible) .     Upon  investigation  it 
is  found  that  the  actual  cash  value  of  the  intangible  at  the 
time  it  was  paid  in,  was  $60,000.    The  amount  included  in 
invested  capital  must  not  exceed   $60,000.     Perhaps  that 
much  may  not  be  allowable.     This  we  shall  determine  as 
we  proceed. 

(b)  *     *     *    must  not  exceed  the  par  value  of  the  stock  or 
shares  issued  therefor. 

It  is  therefore  clear  that  we  may  not  allow  the  $60,000  cash 
value,  for  that  would  exceed  the  "par  value  of  the  stock  or 
shares  issued  therefor." 

OR  (c)  *  *  *  must  not  exceed,  in  the  aggregate,  25 
per  centum  of  the  total  stock  or  shares  of  the  corporation 
outstanding  March  3,  1917,  WHICHEVER  [of  the  three 
restrictions]  IS  LOWEST. 

Now,  what  have  we  ? 

Under  (a)  we  find  that  the  actual  cash 

value  is $60,000 

Under  (b)  we  find  the  par  value  of  the 

shares  issued  therefor  to  be $50,000 

We  find  the  par  value  of  the  stock  out- 
standing March  3,  1917,  to  be $100,000 

Under  (c)  we  find  that  the  amount  to  be 
allowed  may  not  exceed  25  per  centum  of 
this  amount  of  stock,  or $25,000 

Therefore,  the  amount  allowable  is  $25,000,  not- 
withstanding the  value  of  the  acquisition  in  excess 
of  $25,000,  nor  the  excess  of  value  of  the  stock 
over  this  amount. 

Paid  in  Subsequent  to  March  3,  1917 
Intangible  property,  bona  fide  paid  in  for  stock  or 


158  INVESTED  CAPITAL  ACCOUNTING 

shares  on  or  after  March  3,  1917,  is  allowable  in  an  amount 
not  exceeding — 


(a)  The  actual  cash  value  of  such  property  at  the  time  paid  in. 
(Assume  that  we  find  that  the  cash  value  of  a  patent  that 
was  paid  in  for  stock  or  shares  was  $5,000.) 

(b)  *    *    *    not  exceeding  the  par  value  of  the  stock  or  shares 
issued  therefor. 

(Assume  that  stock  to  the  amount  of  $30,000  was  issued 
for  the  patent.) 

OR,  (c)  in  the  aggregate,  25  per  centum  of  the  par  value  of 
the  total  stock  or  shares  of  the  corporation  outstanding:  at 
the  beginning  of  the  taxable  year. 


We  find  that  at  the  beginning  of  the  taxable  year, 
January  1, 1919,  the  par  value  of  the  total  stock  outstanding 
was  $500,000,  and  25  per  cent  of  this  amount  is  $125,000. 
Shall  we  allow  this  amount  on  the  patent  ?  NO !  The  Act 
states  that  the  allowable  amount  is  determined  by  (a), 
(b),  OR  (c),  WHICHEVER  IS  LOWEST.  Inasmuch  as 
the  actual  cash  value  is  lowest,  $5,000  is  the  most  that  is 
allowable. 

Caution 

If,  after  March  3,  1917,  the  corporation  cancelled,  or 
bought  in,  or  there  was  returned  to  it  some  of  its  stock,  say 
in  November,  1917,  goodwill  or  other  intangible  acquired 
for  stock  or  shares  prior  to  March  3,  1917,  should  be  com- 
puted for  1918  upon  the  basis  of  the  amount  of  stock  out- 
standing after  the  acquisition  of  its  stock  by  the  corpo- 
ration, without  regard  to  the  amount  of  stock  outstanding 
on  March  3,  1917. 

Further,  if  the  corporation  issued  additional  stock 
after  March  3,  1917,  the  amount  of  intangibles  allowed 


INVESTED  CAPITAL  ACCOUNTING  159 

(for  which  stock  or  shares  was  issued  prior  to  March  3, 
1917)  should  be  based  on  the  amount  outstanding  on  March 
3,  1917. 

In  other  words,  base  the  amount  of  intangibles  upon 
the  amount  of  stock  outstanding  on  March  3,  1917,  or  on 
the  amount  outstanding  at  the  beginning  of  the  taxable 
year,  whichever  is  lower,  when  arriving  at  the  portion  of 
the  intangibles  to  be  allowed  and  which  was  acquired  prior 
to  March  3,  1917,  by  the  issuance  of  stock  or  shares  of  the 
corporation. 

Goodwill  having  no  value  is  seldom  charged  off.  It 
will  usually  be  found  a  corporation,  which,  owing  to  a  desire 
to  be  conservative,  charges  oif  goodwill,  is  the  concern  that 
really  has  goodwill  of  value.  Corporations  whose  goodwill 
is  without  value  are,  ordinarily,  the  ones  that  continue  to 
carry  it  on  their  books. 

An  Erroneous  Impression 

Some  auditors  have  the  opinion  that  25  per  centum 
of  the  amount  of  stock  outstanding  must  necessarily  be 
allowed;  in  other  words,  they  appear  to  think  that  the 
25%  limit  is  a  minimum  amount.  Such  is  not  the  case. 
The  25%  limit  is  the  maximum  amount  that  is  allowable. 
If  the  intangible  were  found  to  be  of  no  value  at  the  time 
acquired  (and  often  so-called  goodwill  is  valueless)  no 
amount  can  be  allowed. 

An  Important  Exception 

Note  that  the  Act  states:  "If  stock  or  shares  were 
issued  for  intangibles  *  *  *  ."  Any  intangible  pur- 
chased with  cash  or  the  equivalent  of  cash,  is  allowable 
in  an  amount  equal  to  the  cash  paid  for  it  regardless  of 
its  value,  provided,  of  course,  that  the  transaction  was  a 
bona  fide  one  and  not  a  scheme  to  beat  the  government 


160  INVESTED  CAPITAL  ACCOUNTING 

or  to  fill  the  pockets  of  a  favored  stockholder  or  other  per- 
son at  the  expense  of  the  corporation. 


Depreciation  of  Intangibles 

This  phase  of  intangible  computation  is  covered  in  the 
chapter  on  Depreciation. 

An  excellent  exposition  of  the  treatment  of  certain 
kinds  of  depreciation  is  to  be  found  in  Cumulative  Bulle- 
tin, December,  1919,  beginning  at  the  bottom  of  page  133. 
Also,  Article  163,  as  revised,  is  quoted  below,  and  should 
be  studied,  and  if  it  appears  differently  in  your  copy  of  the 
Regulations,  you  should  make  the  necessary  notations  on 
the  margin  of  the  Article  in  your  copy. 

Article  163.  Depreciation  of  intangible  property — "Intangi- 
bles, the  use  of  which  in  the  trade  or  business  is  definitely 
limited  in  duration,  may  be  the  subject  of  a  depreciation  allow- 
ance. Examples  are  patents  and  copyrights,  licenses,  and  fran- 
chises. Intangibles,  the  use  of  which  in  the  business  or  trade 
ia  not  so  limited,  will  not  usually  be  a  proper  subject  of  such  an 
allowance.  If,  however,  an  intangible  asset  acquired  through 
capital  outlay  is  known  from  experience  to  be  of  value  in  the 
business  for  only  a  limited  period,  the  length  of  which  can  be  esti- 
mated from  experience  with  reasonable  certainty,  such  intangible 
assets  may  be  the  subject  of  a  depreciation  allowance,  provided 
the  facts  are  fully  shown  in  the  return  or  prior  thereto  to  the 
satisfaction  of  the  Commissioner." 

A  Hypothetic  Proposition 

The  Miggs  Automotive  Company,  January  1,  1919,  had 
stock  outstanding  in  the  amount  of  $6,000,000,  par  value. 
An  examination  of  the  books  of  the  corporation  discloses 
the  following  intangibles  and  the  manner  in  which  they 
were  acquired  by  the  corporation: 

March  12,  1917,  patent,  $100,000,  paid  for  with  stock. 


INVESTED  CAPITAL  ACCOUNTING  161 

March  20,  1917,  patent,  $30,000,  purchased  for  cash. 

June  12,  1917,  patent,  $52,000,  taken  in  payment  of 
a  note  of  equal  amount.  Note  was  considered  good. 

August  18,  1917,  trade  brand,  $25,000,  taken  in  ex- 
change for  stock  of  the  corporation. 

September  2,  1917,  copyright  on  an  Auto  Instruction 
Book,  $3,000.  Paid  for  by  giving  a  $3,000  automo- 
bile in  exchange  for  the  copyright. 

September  30,  1917,  chemical  formula  for  determining 
the  carbon  content  of  steel.  Cash  value  was  thought 
to  be  $65,000.  Paid  in  for  stock,  $40,000;  cash, 
$30,000. 

December  15,  1917,  goodwill  of  the  Consolidated  Motor 
Company,  $500,000,  paid  in  for  stock.  Conservative 
estimators  regarded  this  as  a  low  price. 

December  15,  1917,  mailing  list  of  auto  users,  paid  in 
for  stock,  $200,000.  List  contains  1,560,000  names. 
Such  lists  are  considered  worth  20  cents  per  name. 

December  20,  1917,  formula  for  making  a  substitute 
for  gasoline  out  of  water  and  ethyl  aldehyde.  Price 
$300,000,  paid  in  for  stock,  $275,000 ;  cash,  $25,000. 
It  proved  to  be  an  impractical  idea. 

In  computing  invested  capital  what  value  shall  we  place 
upon  the  above  intangible  properties  ? 

First,  let  us  tabulate  the  items,  classifying  them  accord- 
ing to  the  nature  of  the  compensation  given  for  them : 


162  INVESTED  CAPITAL  ACCOUNTING 

Other 

Stock                Cash  Property 

Patent   $100,000  

Patent   $30,000  

Patent    $52,000 

Trade  Brand 25,000  

Copyright    3,000 

Formula    40,000  30,000  

Goodwill    500,000  

Mailing    List 200,000  

Formula    275,000  25,000  


Totals $1,140,000  $85,000  $55,000 

85,000 
1,140,000 


Grand  total  of  intangibles $1,280,000 


Second,  we  must  allow  all  the  intangibles  to  the  extent 
that  they  were  acquired  for  cash,  as  follows: 

Patent $30,000 

Part  of  formula 30,000 

Part  of  formula 25,000     $85,000 


Also,  we  must  allow  all  that  was  paid  for 
by  giving  tangible  property  in  exchange, 
based  on  the  cash  value  of  the  tangible  prop- 
erty given  for  the  intangibles. 


Patent    $52,000 

Copyright    3,000       55,000 


Amount  to  be  allowed  that  is  not  subject  to  the  percentage 

limitation $140,000 


Observe  that  Section  326,  (4)  and  (5)  is  so  qualified 
as  to  be  applicable  only  in  instances  where  "intangible  prop- 


INVESTED  CAPITAL  ACCOUNTING  163 

erty  bona  fide  (is)  paid  in  for  stock  or  shares  *  *  *  ." 
Intangible  property  paid  in  for  cash  or  other  tangible  prop- 
erty is  allowable  to  the  extent  of  the  full  value  given 
for  it. 


But  note,  however,  that  if  an  intangible  is  paid  for 
with  another  intangible,  it  amounts  only  to  an  exchange 
of  intangibles,  and  the  25 %  limitation  would  operate  just 
the  same  as  in  any  other  case  of  an  intangible  subject  to 
the  limitation. 


But  to  get  back  to  our  proposition.  Deducting  the 
amount  allowed  above,  $140,000  from  the  grand  total,  leaves 
$1,140,000,  and  we  must  determine  how  much  of  this  amount 
is  allowable. 


At  the  beginning  of  the  taxable  year  the  amount  of 
stock  actually  outstanding  was  $6,000,000.  Twenty-five  per 
cent  of  this  amount  is  $1,500,000,  or  $360,000  in  excess  of 
the  amount  that  was  paid  in  for  stock  or  shares.  Shall  we 
allow  this  amount?  No,  for  we  have  found  that  the  for- 
mula purchased  December  20,  1917,  and  for  which  stock 
was  issued  in  the  amount  of  $275,000,  was  without  value; 
therefore,  we  must  disallow  the  $275,000.  Deducting  $275,- 
000  from  the  balance  of  $1,140,000  leaves  $865,000  allow- 
able to  be  included  in  invested  capital. 

This  adjustment  would  be  made  in  line  1,  Schedule  G, 
and  on  the  working  papers  there  might  appear  a  table  of 
intangibles  made  up  similar  to  the  table  presented  on  a 
previous  page. 

Under  Gl  (page  4  of  Form  1120)  we  find  "  *  *  * 
the  amount  by  which  (f)  exceeds  (b)  or  (c)  *  *  *  ." 


164  INVESTED  CAPITAL  ACCOUNTING 

(f )  equals  the  value  as  carried  on  the  books 
of  the  corporation;  that  is,  $1,280,000 
less  the  amount  paid  for  with  cash  or 
other  tangible  property,  or $1,140,000 

(b)  equals  the  cash  value;  that  is,  $1,140,000 

less  the  worthless  formula 865,000 


Inasmuch  as  (b)  does  not  exceed  25  per 
centum  of  (e)  the  amount  to  be  deducted 
in  line  1,  Schedule  G,  is $275,000 


You  will  observe  from  a  study  of  the  above  that  the 
25%  limitation  does  not  embrace,  or  include,  the  intangibles 
acquired  and  which  were  not  paid  for  in  stock  or  shares 
of  the  corporation.  To  illustrate  further: 

The  Starr  Company  had  stock  outstanding  as  at  Jan- 
uary 1,  1919,  amounting  to  $400,000.  July  10,  1918,  it  paid 
$100,000  cash  for  a  patent.  On  the  same  day  it  acquired 
the  goodwill  of  the  Moon  Company  for  $100,000  stock  of 
the  corporation.  We  will  not  question  the  value  placed  on 
the  goodwill. 

The  Starr  Company  is  entitled  to  inclusion  in  its  in- 
vested capital  the  total  amount  of  intangibles  carried  on 
its  books;  that  is,  25%  on  $400,000,  for  the  goodwill,  and, 
in  addition,  the  patent  intangible  for  which  cash  was  paid. 
In  other  words,  the  payment  of  cash  or  other  tangible  prop- 
erty (at  cash  value)  for  an  intangible,  removes,  in  a  sense, 
the  intangible  from  the  realm  of  intangibles — gives  it  the 
status  of  a  tangible. 

Development  of  Patents,  Etc.,  by  a  Corporation 

Many  concerns  employ  a  staff  of  inventors,  experi- 
menters and  investigators  to  develop  or  improve  machines 
or  other  things  along  certain  lines. 


INVESTED  CAPITAL  ACCOUNTING  165 

Assuming  that  a  corporation  in  this  way  becomes  the 
owner  of  a  very  valuable  patent,  it  will  not  be  permitted 
the  corporation  to  carry  this  patent  as  an  asset,  for  invested 
capital  purposes,  in  any  amount  greater  than  the  amount 
it  actually  cost  the  corporation  to  produce  or  perfect  the 
patent,  in  which  cost  may  be  included  government  fees, 
attorney  fees,  the  cost  of  making  patent  and  other  draw- 
ings, stenographic  help,  etc. 

Where  the  cost  of  developing  patents  has  been  charged 
to  current  expense  since  January  1,  1909,  the  amount  so 
charged  can  not  now  be  set  up  as  an  asset.  Where  such 
cost  of  development  has  been  charged  to  Surplus,  or  other- 
wise disposed  of  in  such  a  way  as  not  to  reduce  the  net 
taxable  income  of  the  corporation,  any  amount  so  written 
off  may  be  restored  in  computing  invested  capital. 

This  feature  of  intangibles  is  pretty  well  covered  in 
Article  843,  and  you  should  make  a  thorough  study  of  it. 

Mixture  of  Tangibles  and  Intangibles 

The  Gary  Company  bought  out  the  partnership  of 
Anderson  Brothers,  paying  therefor  $200,000.  Of  this 
amount,  $125,000  was  paid  for  in  stock  of  the  Gary  Com- 
pany and  $75,000  in  bonds  of  the  Company.  In  the  deal 
the  corporation  assumed  liabilities  of  Anderson  Brothers 
amounting  to  $25,000. 

The  following  assets  were  acquired  in  the  transaction : 

Factory   Building $60,000 

Machinery 38,000 

Goods  in  Process 55,000 

Finished    Goods 20,000 

Patents    12,0(10 

Goodwill 40,000 


Total $225,000 


166  INVESTED  CAPITAL  ACCOUNTING 

Two  questions  arise  here.  (1)  Did  the  corporation 
pay  for  the  patents  and  the  goodwill  by  issuing  stock,  or 
did  it  pay  for  the  intangibles  by  giving  bonds  for  them? 
Upon  the  answer  to  this  question  depends  whether  the 
25%  limitation  shall  or  shall  not  apply.  If  the  bonds  paid 
for  the  intangibles,  the  25%  limitation  does  not  obtain,  for 
bonds  are  the  equivalent  of  cash. 

(2)  Did  the  liabilities  assumed,  amounting  to  $25,000 
partly  pay  for  the  tangibles  or  for  the  intangibles?  If  be- 
coming liable  for  the  liabilities  paid  for  the  intangibles,  the 
25%  limitation  does  not  apply  to  the  intangibles  to  the 
extent  of  $25,000,  for  here,  again,  the  corporation  would 
be  acquiring  intangibles  in  exchange  for  that  which  is  the 
equivalent  of  cash.  The  limitation,  would,  however,  apply 
to  the  intangibles  in  excess  of  the  $25,000. 

Right  here  is  where  Article  835  applies.  Refer  to  it 
and  make  a  careful  study  of  it.  Note  that  we  must  assume 
that  the  bonds  paid  for  the  tangible  property,  or  for  an 
amount  of  tangible  property  equal  to  the  amount  of  the 
bonds,  therefore,  of  the  $173,000  tangibles  acquired,  $75,000 
worth  of  them  were  taken  in  exchange  for  bonds  of  the 
corporation. 

We  find,  also,  that  the  $25,000  debts  assumed  pay  for 
tangibles,  and  that  stock  paid  for  the  remainder  of  the 
tangibles  and  for  all  of  the  intangibles,  hence  the  25%  limi- 
tation applies. 

Assuming  that  the  corporation  had  capital  stock  out- 
standing at  the  beginning  of  the  taxable  year,  amounting 
to  $100,000,  we  can  allow  intangibles  only  to  the  amount 
of  $25,000  (25%  of  $100,000)  and  the  difference  between 
this  amount  that  is  allowable  and  the  total  amount  of  in- 
tangibles carried,  amounting  to  $52,000,  or  $27,000,  must 
be  deducted  in  line  1,  Schedule  G. 

Let  it  be  stated  in  another  way:   For  this  same  prop- 


INVESTED  CAPITAL  ACCOUNTING  167 

erty  there  was  issued,  stock,  $35,000 ;  bonds,  $150,000,  and 
the  liabilities  assumed  amounted  to  $40,000. 

The  tangibles  amount  to  $173,000.  The  bonds  given 
and  the  liabilities  assumed  amount  to  $190,000.  After  pay- 
ing for  the  tangibles,  we  have  $17,000  remaining  to  apply 
against  intangibles.  This  amount  of  intangibles  must  be 
allowed,  and,  in  addition,  25%  on  the  $100,000  stock  out- 
standing at  the  beginning  of  the  taxable  year.  Total  in- 
tangibles, $52,000;  paid  in  for  bonds,  $17,000;  25%  allow- 
ance, $25,000;  total  intangibles  to  be  included  in  invested 
capital,  $42,000;  amount  to  be  deducted  in  line  1,  Schedule 
G,  $10,000. 

Note  that  the  Regulations  state:  "at  the  beginning 
of  the  taxable  year."  If  a  corporation  files  its  return  on 
a  fiscal  year  basis,  intangible  allowance  should  be  computed 
on  the  basis  of  the  amount  of  stock  outstanding  as  at  the 
first  day  of  the  corporation's  fiscal  year,  and  not  on  the 
amount  that  might  have  been  outstanding  at  January  1. 

A  Different  Proposition 

In  January,  1910,  the  Bond  Company  issued  $100,000 
stock,  par  value,  for  a  patent,  and  $50,000  stock  for  a  secret 
formula.  On  March  3,  1917,  the  outstanding  capital  stock 
was  $600,000.  This  would  entitle  the  corporation  to  include 
in  invested  capital  intangible  assets  amounting  to  $150,000, 
provided,  of  course,  that  it  produces  evidence  in  support 
of  the  claim  that  the  intangibles  were  worth  that  amount 
at  the  time  they  were  paid  in. 

At  January  1,  1919,  the  corporation  had  capital  stock 
outstanding  amounting  to  $1,000,000.  It  buys,  November 
30,  1918,  a  trade-mark,  conservatively  said  to  be  worth 
$200,000,  and  for  which  there  is  issued  stock  of  the  cor- 
poration to  the  amount  of  $250,000. 

How  much  intangible  assets  shall  we  allow  this  cor- 
poration to  include  in  its  invested  capital  ? 


168  INVESTED  CAPITAL  ACCOUNTING 

Shall  we  limit  it  to  the  original  $150,000  on  the  basis 
of  the  stock  outstanding  March  3,  1917?  No! 

Shall  we  limit  it  to  $200,000,  the  apparent  value  of 
the  trade-mark  acquired  in  November,  1918?  No! 

Shall  we  allow  intangibles  amounting  to  $150,000  plus 
the  $200,000,  or  a  total  of  $350,000?  Again,  NO! 

The  Act,  under  Section  326,  (5),  states:  "Provided, 
that  in  no  case  shall  the  total  amount  included  under  para- 
graphs (4)  and  (5)  exceed  in  the  aggregate  25  per  centum 
of  the  par  value  of  the  total  stock  or  shares  of  the  cor- 
poration outstanding  at  the  beginning  of  the  taxable  year." 

Inasmuch  as  the  total  par  value  of  the  stock  outstand- 
ing at  the  beginning  of  the  taxable  year  amounted  to  $1,000,- 
000,  we  should  allow  intangibles  to  be  included  in  invested 
capital  to  the  amount  of  $250,000. 

Attempting  the  Impossible? 

Section  326,  (5),  (a)  states,  "The  actual  cash  value 
of  such  (intangible)  property  at  the  time  paid  in."  It 
would  appear  that  this  statement  could  have  been  more 
appropriately  worded,  for  by  inference  we  are  instructed 
to  do  that  which  is  next  to  impossible,  if  not  altogether 
impossible. 

Unless  the  intangible  was  purchased  for  cash,  or  for 
the  equivalent  of  cash  (and  even  then  actual  value  is  not 
established)  it  is  extremely  doubtful  if  you  will  ever  have 
occasion  to  audit  a  case  where  the  "actual  cash  value  at 
the  time  paid  in"  is  possible  of  determination. 

If  stock  or  shares  were  issued  for  an  intangible,  you 
might  determine  that  the  intangible  had  no  cash  value;  in 
other  words,  that  it  was  worthless,  or  it  might  easily  be 
apparent  that  the  intangible  had  some  value,  and,  at  the 
same  time,  it  would  be  utterly  impossible  to  arrive  at  what 
the  "actual  cash  value"  was. 


INVESTED  CAPITAL  ACCOUNTING  169 

Unless  it  can  be  shown  that  the  intangible  has  no  value, 
it  seems  to  be  the  custom  to  grant  the  25%  limit  and  not 
to  attempt  a  hair-splitting  act  by  trying  to  arrive  at  a 
dividing  line  between  some — an  indeterminate — value  and 
the  amount  that  is  allowable  within  the  other  limitations. 

Article  851  is  intended  as  an  aid  in  this  direction,  and 
it  should  be  studied  and  re-studied.  It  appears,  however, 
that  instead  of  this  article  applying  to  the  general  run 
of  cases  it  can,  from  the  very  nature  of  intangibles,  and 
from  lack  of,  or  inability  to  obtain,  any  definite  conditions 
as  are  therein  outlined,  be  applicable  only  in  very  excep- 
tional cases.  See  Bulletin  10-20-777 — A.R.M.  34  for  methods 
of  determining  the  value  of  intangibles. 


Goodwill  and  No-Par-Value  Stock 

The  Johnson  Machine  Co.  has  outstanding,  January  1, 
1918,  Common  Stock,  amounting  to  $100,000,  par  value. 
Also,  it  issued  in  December,  1917,  1,000  shares  of  no-par- 
value  stock.  On  what  amount  of  stock  shall  we  base  the 
intangibles  ? 

First,  we  will  allow  (assuming  that  the  intangible  has 
value)  25%  on  the  $100,000  Common  Stock.  Second,  we 
must  ascertain  the  value  of  the  no-par-value  stock  as  at 
the  date  or  dates  of  issue  by  finding  what  amount  of  value, 
in  dollars,  was  received  for  the  stock.  We  will  then  allow 
25%  on  this  value. 

Thus,  in  the  above  instance,  it  is  found  that  the  1,000 
shares  sold  for  $70  per  share — total  $70,000.  We  will  allow 
$25,000  on  the  Common  Stock  plus  25%  on  the  value  of 
the  no-par-value  stock,  or  $17,500,  making  a  total  of  $42,500 
allowable.  See  April,  1920,  Digest,  bottom  of  page  168. 


170  INVESTED  CAPITAL  ACCOUNTING 

Proration  of  Intangibles 

The  question  is  often  asked:  Shall  we  ever  prorate 
intangible  assets  acquired  during  the  year  or  sold  during 
the  year?  The  Regulations  do  not  cover  the  subject  specif- 
ically but  we  may  assume  that  under  certain  conditions 
there  would  be  a  proration  of  intangibles  based  on  the 
requirement  that  the  invested  capital  of  a  concern  for  a 
given  period  is  the  average  invested  capital  for  the  period, 
not  the  amount  of  invested  capital  the  concern  had  at  the 
beginning  or  at  the  end  of  the  period. 

We  shall  make  four  assumptions.  The  writer  wishes 
you  to  understand  that  the  views  expressed  on  this  subject 
are  not  in  any  sense  official  views — they  are  his  personal 
views  and  the  views  of  some  of  his  able  friends  whom  he 
has  consulted.  He  would  suggest  that  you  weigh  this  sub- 
ject carefully  and  base  your  conclusion  on  your  own  judg- 
ment as  determined  by  the  actual  facts  found  in  the  in- 
stant case. 

(a)  A  Corporation  has,  let  us  say,  $400,000  capital 
stock  outstanding  at  the  beginning  of  the  taxable  year. 
It  claims  intangible  assets  amounting  to  $140,000,  all  of 
which  were  acquired  by  the  issuance  of  stock  or  shares. 
Of  this  amount  we  would  disallow  $40,000  on  the  principle 
that  the  amount  of  intangibles  allowed  shall  not  exceed 
25  per  centum  of  the  capital  stock  outstanding  at  the  begin- 
ning of  the  taxable  year.    During  the  year  it  is  assumed 
that  the  concern  issued  additional  stock  for  cash  or  property 
or  other  intangibles.    Shall  we  allow  the  additional  amount 
of  intangibles?     The  answer  is  "no."     We  have  already 
allowed  the  limit  permissible  under  the  law. 

(b)  Take  the  same  corporation,  having  $400,000  cap- 
ital stock  outstanding    at  the  beginning    of  the  taxable 
period.     It  claims  intangibles  to  the  amount  of  $75,000, 
which  were  acquired  for  stock  or  shares.    During  the  year 
it  issued  additional  stock  for  $100,000  more  intangibles. 


INVESTED  CAPITAL  ACCOUNTING  171 

Shall  we  allow  any  in  addition  to  the  $75,000  already 
allowed?  The  writer  believes  that  we  should  allow  the 
amount  which,  prorated,  would  be  equal  to,  but  not  in 
excess  of  25  per  centum  of  the  capital  stock  outstanding 
at  the  beginning  of  the  taxable  year.  In  no  instance  does 
the  law  or  the  regulations  specify  that  the  intangibles 
allowed  must  have  been  held  at  the  beginning  of  the  tax- 
able period, 

(c)  Again  assume  a  corporation  with  $400,000  capital 
stock  outstanding  at  the  beginning  of  the  taxable  period. 
The  corporation  claims  intangibles  to  the  amount  of  $200,- 
000,  all  of  which  were  acquired  by  the  issuance  of  stock 
or  shares.    Under  the  law  we  will  disallow  $100,000  of  this 
amount  and  will  allow  $100,000.    Now  we  will  assume  that 
the  $200,000  intangibles  is  made  up  of  four  different  pat- 
ents. We  will  concede  that  all  of  these  patents  are  valuable. 
During  the  year  the  concern  sells  one  of  the  patents  for 
$50,000  in  cash  or  the  equivalent  of  cash.     The  question 
is:   Does  this  affect  invested  capital?    The  writer  believes 
that  we  should  add  $50,000  to  the  invested  capital  prorated 
as  at  the  date  of  sale.    He  assumes,  of  course,  that  the 
element  of  profit  does  not  enter  into  this  transaction — that 
the  $50,000  received  for  the  patent  was  the  value  of  the 
stock  issued  therefor. 

(d)  Let  us  carry  assumption  (c)  a  little  further.    This 
corporation  sells  all  of  the  intangibles  for  $200,000  cash  or 
the  equivalent  of  cash  December  2  during  the  taxable  year. 
It  is  assumed  that  the  $200,000  contains  no  element  of 
profit.    How  shall  this  be  treated  ?    The  writer  would  allow 
intangibles  based  on  25  per  centum  of  the  capital  stock 
outstanding  at  the  beginning  of  the  taxable  year  multiplied 
by  335/365  of  a  year  and  he  would  allow  the  $200,000  to 
be  brought  into  invested  capital  multiplied  by  30/365  of 
a  year. 


172  INVESTED  CAPITAL  ACCOUNTING 

Things  to  Remember 

Intangibles  paid  for  with  cash  or  its  equivalent  are 
allowable  without  limitation. 

Intangibles  acquired  in  any  other  way  are  subject  to 
the  limitations  specified  under  Section  326. 

There  is  a  maximum  amount  that  can  be  allowed  when 
paid  in  for  stock  or  shares  of  the  corporation.  There  is 
no  minirrium  limitation. 

That  the  limitation  is  based  on  the  amount  of  capital 
stock  outstanding  at  the  beginning  of  the  taxable  year. 
This  means  that  if  a  corporation  issues  stock  during  the 
taxable  year  that  additional  stock  can  not  be  included  in 
arriving  at  the  amount  of  intangibles  allowable. 

It  should  be  noted  that  items  of  experimental  expenses, 
as  the  development  of  patents,  the  protection  of  copyrights 
and  like  items  that  have,  since  January  1, 1909,  been  charged 
to  expense,  can  not  now  be  restored  to  invested  capital.  It 
would  seem,  however,  that  such  items  of  expense  created 
prior  to  January  1,  1909,  may  be  restored  to  invested  cap- 
ital, provided,  it  can  be  shown  that  such  items  were  in 
reality,  proper  capital  expenditures.  Carefully  re-study 
Article  843. 

Observe  that  Goodwill  placed  on  the  books  with  a  corre- 
sponding credit  to  Surplus,  for  which  nothing  was  paid 
(either  cash,  property,  or  stock  or  shares)  has  no  standing 
whatever.  It  has,  in  effect,  the  status  of  appreciation  of 
values  so  far  as  invested  capital  is  concerned  and  whatever 
the  amount  may  be  it  must  be  disallowed;  it  is  not  even 
given  the  benefit  of  the  25%  limitation. 


CHAPTER  TEN 
ADMISSIBLES  AND  INADMISSIBLES 

In  the  chapter  on  tangible  property  and  intangible  prop- 
erty you  were  told  that  all  assets  must  be  included  in  one 
or  the  other  of  these  classifications.  And  so  it  is  in  the 
present  case — all  assets  must  be  classified  either  as  admissi- 
bles,  or  as  inadmissibles.  There  is  no  middle-of-the-road 
class.  Any  asset  that  is  not  an  inadmissible  asset  is  an 
admissible  asset. 

Chapter  Nine  was  wholly  devoted  to  the  methods  of 
ascertaining  the  value  at  which  certain  assets  may  be 
included  in  invested  capital.  The  aim  of  this  chapter  is 
to  teach  you  how  to  determine,  not  the  value  of  the  asset, 
but  rather  the  proportionate  amount  of  certain  assets  that 
must  be  excluded  from  invested  capital. 

There  is  but  little  connection  between  the  classifica- 
tions described  in  Chapter  Nine  and  the  classifications  de- 
scribed in  the  present  chapter.  Tangible  property  may  be 
admissible,  or  it  may  be  inadmissible.  Intangible  property 
can  not  be  inadmissable. 

What  Is  an  Inadmissible  Asset? 

When  we  say  that  an  asset  is  "inadmissible"  it  is  not 
intended  to  convey  the  impression  that  it  is  to  be  excluded 
from  the  Balance  Sheet.  All  inadmissibles  properly  belong 
in  the  concern's  assets  to  the  full  amount  of  their  cost; 
in  other  words,  they  are  not  subject  to  a  percentage  limita- 
tion as  are  intangibles. 


174  INVESTED  CAPITAL  ACCOUNTING 

What  is  meant  by  the  use  of  the  term  "inadmissible" 
is  that  any  such  asset  is  not  to  be  reflected  in  the  final 
invested-capital-surplus,  except  under  specific  conditions 
and  to  a  certain  extent  as  will  be  fully  explained  as  we 
proceed. 

All  admissible  assets  other  than  intangibles  must  be 
reflected  on  the  liabilities  side  of  the  balance  sheet  at  their 
cost  less  depreciation  and  depletion,  if  any.  Intangible 
assets  are  admissible  assets  to  the  full  amount  of  their  cost 
(less  depreciation,  etc.,  if  any)  except  when  acquired  by 
the  issuance  of  stock  or  shares,  when  the  amount  at  which 
they  may  be  reflected  in  invested  capital  must  be  reduced 
as  explained  in  Chapter  Nine.  However,  the  reduction  of 
the  amount  does  not  cause  the  intangibles  to  become  in- 
admissible. They  must  be  classed  as  admissible  assets. 

An  inadmissible  asset  is  an  obligation  carried  by  a  cor- 
poration, the  dividends  or  interest  from  which  are  not 
subject  to  excess  or  war  profits  taxes.  Article  815. 

Note  that  "dividends"  or  "interest"  is  specified.  The 
profit  that  may  be  derived  from  the  sale  of  an  inadmissible 
is  not  a  dividend ;  neither  is  it  interest.  The  profit  derived 
from  the  sale  of  an  inadmissible  is  subject  to  income  and 
excess  profits  taxes  to  the  same  degree  that  any  profit 
that  is  the  result  of  the  regular  operations  of  the  business 
is  taxable. 

What  ARE  the  Inadmissibles? 

The  inadmissibles  are  few  in  number,  but  important. 
In  the  chapter  on  tangibles  and  intangibles  it  was  said 
that  it  were  easier  to  name  the  intangibles  than  to  specify 
the  tangibles.  This  is  equally  true  in  the  present  instance 
— it  is  easier  to  name  the  inadmissibles  than  it  is  to  name 
the  admissibles.  The  chief  (perhaps  all)  inadmissibles  are: 


INVESTED  CAPITAL  ACCOUNTING  175 

Stocks  of  other  domestic  corporations, 

Stocks  of  foreign  corporations  deriving  income 
from  sources  within  the  United  States, 

Bonds  of  Porto  Rico, 

Bonds  of  the  War  Finance  Corporation,  to  the 
amount  of  $5,000  (any  amount  held  in  excess  of 
$5,000  is  admissible), 

Federal  Farm  Loan  Bonds, 
Federal  Reserve  Bank  Stock, 

Bonds  of  a  Territory,  State,  County,  Township, 
City,  Borough,  or  other  political  sub-division  of 
a  state  (or  territory), 

District  of  Columbia  obligations,  or  obligations  of 
any  other  possession  of  the  United  States.  See 
Article  816. 

Confusion  Sometimes  Created  Where  None  Should  Exist 

Perhaps  you  have  heard  that  confusing  play  on  words 
— an  intangible  inadmissible,  or,  an  inadmissible  intangible. 
Sounds  formidable,  does  it  not  ?  Do  not  permit  it  to  bother 
you.  There  is  no  such  thing.  A  very  good  authority  en- 
deavored to  convince  the  writer  that  such  a  thing  could 
be,  but  he  afterward  admitted  that  he  was  mistaken.  All 
intangible  assets  (note  that  we  specify  assets,  which  means 
things  of  worth)  are  admissible  assets.  They  may  come 
within  the  25%  limitation  but  they  are  admissible,  never- 
theless. The  amount  in  excess  of  25%,  that  is  disallowed, 
is  not  to  be  regarded  as  an  asset,  and,  not  being  an  asset, 
it  can  be  neither  an  admissible  nor  an  inadmissible  asset. 

Computation  Not  Difficult 

Many  appear  to  think  that  to  arrive  at  an  understand- 


176  INVESTED  CAPITAL  ACCOUNTING 

ing  of  the  correct  treatment  of  inadmissibles  is  a  difficult 
mental  process.  This  is  an  erroneous  impression.  It  is 
just  as  easy  and  simple  to  calculate  the  adjustment  neces- 
sary in  respect  of  inadmissibles  as  it  is  to  adjust  invested 
capital  on  the  basis  of  the  income  and  profits  taxes  that 
are  payable  at  a  given  date,  by  pro-rating  the  amount  over 
the  period,  and  in  this  respect  (the  pro-ration)  the  pro- 
cedure necessary  to  adjust  for  inadmissibles  is  exactly  the 
same  (provided,  of  course,  that  the  amount  held  changes 
during  the  taxable  year ;  otherwise,  there  is  no  pro-ration) . 

A  great  trouble  with  most  of  us  is,  "scattered  vision." 
When  we  take  up  a  balance  sheet  having  inadmissibles  to 
consider  and  other  items  to  adjust,  we  are  apt  to  look  at 
the  work  involved  in  the  aggregate.  That  attitude  always 
causes  more  or  less  confusion.  The  best  way  is  to  take 
up  each  item  by  itself,  entirely  independent  of  any  other 
adjustment  that  may  have  to  be  made — go  about  it  just 
as  one  would  if  there  were  no  other  adjustments  to  be  made. 
No  one  balance  sheet  adjustment  is  difficult.  It  is  only 
when  we  mentally  collate  them  and  contemplate  the  total 
work  apparent  that  the  task  seems  difficult.  Think  of  but 
one  adjustment  at  a  time.  Decide  just  how  it  should  be 
treated  and  then  adjust  IT.  When  the  first  one  is  done, 
take  up  the  next  one  in  the  same  way,  and  continue  thus 
until  the  adjustments  are  completed. 

A  good  plan  to  follow  is  to  make  up  a  new  balance  sheet, 
placing  each  asset  at  an  amount  that  represents  its  cost 
at  the  time  of  acquirement  less  any  valuation  reserves  that 
may  or  should  apply  thereto  (except  Reserve — or  Allow- 
ance— for  Doubtful  Accounts).  In  making  up  such  a  bal- 
ance sheet  evaluate  only  one  item  at  a  time.  If  you  will 
make  certain  to  get  the  present  one  right,  your  invested 
capital  is  bound  to  be  correct.  It  may  be  well  to  illustrate 
this  method  now.  We  will  take  the  following  untechnical 
balance  sheet  presumably  furnished  by  a  taxpayer  and  ad- 
just the  items  to  their  invested  capital  values — 


INVESTED  CAPITAL  ACCOUNTING  177 

Assets  Liabilities  and  Capital 

Cash    $1,000   Capital    Stock $80,000 

Accounts     Receiv-  Surplus   97,000 

able  $12,000  Undivided  Profits 8,000 

Less:      Allowance  Notes  Payable 10,000 

for  Bad  Debts ..     1,000     11,000  Reserve  for  Depreciation.     2,000 

Reserve  for  Improvements  10,000 

Patents    15»°° }  Reserve  for  Machinery. . .     5,000 

Inventory    36,000  Reserve  for  Patent  Devel- 

Buildings    20>000       opment   5,000 

Land    15»00()  Reserve  for  Unpaid  Divi- 

R.  R.  Bonds 5,000  dends                                     !  000 

R.  R.  Stock* 5,000 

Pa.  State  Bonds* 5,000 

Chicago  City  Bonds* 5,000 

Treasury  Stock 20,000 

Goodwill    80,000 


$218,000  $218,000 


Upon  investigation  we  find  the  following  to  be  the  facts : 
Amount  of  Cash,  $1,000  is  correct. 

Accounts  Receivable  account  is  correct,  but  we  do  not 
allow  the  allowance  of  $1,000  as  a  deduction  from  gross 
income,  hence,  since  every  such  item  must  either  be  allowed 
as  a  deduction  or  it  must  be  reflected  in  surplus,  we  will 
have  to  allow  the  face  value  of  the  accounts — $12,000. 

We  find  that  the  patents  cost,  in  cash  at  time  of  acquire- 
ment, $5,000  and  that  development  expenses  amounting  to 
$3,000  have  been  capitalized.  The  patents  are  found  to  be 
valuable  and  the  price  at  which  they  are  carried  is  very 
reasonable.  But  all  we  can  allow  is  cost — $8,000. 

The  stock  in  trade  inventoried  $40,000  at  cost  but  the 
concern,  fearing  declines  in  prices,  wrote  off  1Q%.  We 
must  allow  the  full  $40,000. 


178  INVESTED  CAPITAL  ACCOUNTING 

We  find  that  the  buildings  cost  $20,000  six  years  ago 
and  that  their  probable  life  is  twenty  years.  It  is  evident 
that  they  are  being  carried  at  an  inflated  amount ;  that  they 
should  be  carried  at  $14,000. 

The  land  cost  $15,000,  hence  that  is  the  invested  cap- 
ital sum. 

We  will  pass  by  the  three  inadmissible  items  marked 
with  stars  (*)  except  that  we  have  ascertained  that  the 
amounts  at  which  they  are  carried,  as  well  as  the  $5,000 
of  R.  R.  bonds  (which  is  an  admissible  asset)  are  the  actual 
cost  figures. 

We  have  learned  that  Treasury  Stock  is  not  an  asset — 
that  it  is  a  valuation  account. 

We  find  that  $40,000  of  the  Goodwill  was  acquired  by 
the  issuance  of  stock  back  in  1914,  and  that  included  in 
the  $80,000  amount  was  the  purchase,  for  $20,000  cash,  the 
sole  right  to  sell  certain  goods  in  a  certain  section.  Since  then 
the  business  has  been  very  prosperous  and  the  Goodwill 
is  worth  much  more  than  $80,000.  How  much  of  Goodwill 
shall  we  allow?  The  amount  of  stock  outstanding  has  not 
changed  since  the  acquirement  by  purchase  at  par,  of  the 
treasury  stock.  We  can  allow  the  $20,000  cash-purchase 
amount  at  full  cost.  We  can  also  allow  25%  of  the  par 
value  of  the  stock  outstanding  at  the  beginning  of  the  tax- 
able year,  or  ($80,000— $20,000)  x25%=$15,000.  This 
amount,  plus  $20,000  equals  $35,000  to  be  allowed  in  the 
place  of  the  $80,000  carried  on  the  books. 

Now  let  us  set  up  our  adjusted  balance  sheet.  In  so 
doing,  we  need  only  three  items  on  the  liabilities  side — Cap- 
ital Stock,  Creditor  Liabilities  and  Surplus. 


INVESTED  CAPITAL  ACCOUNTING  179 

Adjusted  Balance  SJieet 

Assets  Liabilities  and  Capital 

Cash   $1,000   Capital  Stock. .  .$80,000 

Accounts    Receivable 12,000       Less  Treasury 

Patents   8,000  Stock 20,000     $60,000 

Inventory   40,000    , 

Buildings    14000   °ebt* "'««« 

Land    .    15,000    SurPlus   74'°°° 

R.  R.  Bonds 6,000 

R.  R.  Stock 5,000 

Pa.  State  Bonds 5,000 

Chicago  City  Bonds 5,000 

Goodwill    35,000 


$145,000  $145,000 


If  none  of  the  above  assets  were  inadmissible,  we  would 
now  have  the  amount  of  this  concern's  invested  capital; 
Capital  Stock,  $60,000  plus  Surplus,  $74,000;  total,  $134,000. 
Before  we  can  arrive  at  the  true  statutory  invested  capital 
we  have  one  more  adjustment  to  make — an  adjustment  on 
account  of  the  inadmissibles  carried — and  as  to  just  how 
that  is  done  in  every  conceivable  case  is  what  the  author 
hopes  to  demonstrate  to  you  in  this  chapter. 

Remember  this:  The  adjustment  to  be  made  by  reason 
of  inadmissibles  carried  is  the  LAST  adjustment  to  be 
made  in  computing  invested  capital. 

Why  Divided  Into  These  Two  Classes 

The  reason  for  making  a  distinction  between  the  assets 
that  are  called  admissibles  and  the  assets  that  are  called 
inadmissibles  is  that  a  concern  that  carries  inadmissibles 
is  allowed  less  invested  capital  than  it  would  be  allowed  if 
all  of  its  assets  were  admissible  assets. 


180  INVESTED  CAPITAL  ACCOUNTING 

The  amount  of  profits  taxes  depends,  in  large  measure, 
on  the  amount  of  the  invested  capital.  Inasmuch  as  inad- 
missibles  do  not  contribute  anything  to  income  that  is  sub- 
ject to  the  profits  taxes  it  follows  that  it  would  be  unfair 
to  the  government  to  permit  a  corporation  to  include  in 
invested  capital  any  asset  that  does  not  contribute  income 
that  is  taxable. 


Differentiate  Between  Bonds 

Distinguish  clearly  between  bonds  owned  by  a  corpo- 
ration and  bonds  OWED  by  a  corporation.  The  former  are 
assets;  the  latter  are  liabilities.  The  terms  "inadmissible" 
and  "admissible"  have  no  connection  with  liabilities. 

Also,  distinguish  clearly  between  industrial  bonds, 
which  are  obligations  of  a  private  concern,  such  as  a  manu- 
facturing company,  or  a  transportation  corporation,  and 
bonds  issued  by  a  state,  city,  county,  or,  etc.,  which  are 
obligations  of  the  public.  Industrial  bonds  are  admissible 
assets  because  the  interest  from  them  is  subject  to  tax.  The 
others  are  inadmissible  because  the  interest  they  return  is 
not  subject  to  tax. 

In  this  connection,  you  may  have  to  exercise  a  great 
deal  of  caution  in  certain  instances.  For  example,  bonds 
might  be  issued  by  the  Logan  County  Irrigation  Project. 
You  would  have  to  ascertain  whether  these  bonds  were 
issued  by  the  County  of  Logan,  or  by  a  private  corporation 
doing  business  under  this  name.  Similar  conditions  may 
arise  in  other  lines  of  business,  as  road  building  projects, 
water  companies,  and  other  public  utility  enterprises,  which 
may  be  owned  by  a  municipality,  or  which  may  be  owned 
by  corporations. 


INVESTED  CAPITAL  ACCOUNTING  181 

The  Dividing  Line 

To  ascertain  whether  or  not  any  given  asset  is  ad- 
missible or  inadmissible,  determine  the  answer  to  this 
question : 

Is  the  income  (interest  or  dividends)  that  the  cor- 
poration receives  or  might  receive  from  the  asset  re- 
quired by  law  to  be  included  in  taxable  income  ? 

If  the  answer  is  "yes,"  then  it  is  an  admissible  asset. 
If  the  answer  is  "no,"  then  it  is  an  inadmissible  asset. 

The  exception  to  this  rule  is,  of  course,  obligations  of 
the  United  States.  See  Article  816. 


The  Simplest  Computation 

In  the  event  that  you  audit  the  return  of  a  corpo- 
ration presenting  nothing  on  the  liabilities  side  of  its  balance 
sheet  but  invested  capital  items,  you  simply  deduct  from 
the  total  of  the  invested  capital  items  the  total  of  the 
inadmissibles  carried,  thus: 

Assets  Liabilities  and  Capital 

Cash    $50,000   Capital  Stock $200,000 

Plant   150,000  Reserve  for  Extensions . .  145,000 

A.  T.  Co.  Bonds 30,000    Surplus   100,000 

Municipal    Bonds 100,000    Undivided  Profits 55,000 

Lee  Company  Stock 150,000 

Railroad    Stock 20,000 


$500,000  $500,000 


The  invested  capital  items  amount  to $500,000 

Deduct:  Railroad  Stock $20,000 

Municipal   Bonds 100,000 

Lee  Company  Stock 150,000       270,000 


Invested  Capital $230,000 


182  INVESTED  CAPITAL  ACCOUNTING 

If  total  assets  are  greater  or  less  at  the  end  of  the 
period  than  at  the  beginning,  or  if  the  amount  of  inad- 
missibles carried  has  changed  during  the  year,  this  method 
is  not  applicable.  You  will  not  have  occasion  to  audit 
many  cases  of  this  kind,  but  occasionally  one  of  such 
"turns  up." 


The  Usual  Procedure 

(1)  The  first  thing  to  do,  when  adjusting  a  balance 
sheet  presenting  inadmissibles,  is  to  adjust  each  asset  to 
its  true  invested-capital-value  basis.    See  Article  818. 

(2)  The  second  operation  is  to  find  the  total  of  the 
inadmissibles   and   the   total   of   the   inadmissibles   AND 
admissibles. 


(3)   Ascertain  the  percentage  rate  that  the  inadmissi- 
bles bear  to  the  total  of  the  admissibles  and  inadmissibles. 


(4)  Compute  the  amount  of  the  invested  capital  items. 

(5)  Use  the  amount  found  under  (4)  as  a  multipli- 
cand and  the  percentage  found  under  (3)  as  a  multiplier. 
The  product  is  the  amount  that  must  be  deducted  from  the 
amount  found  under  (4).    Study  Article  852. 


Problem  Illustrating  the  Above 

We  shall  assume,  for  our  present  purpose,  that  all 
assets  remained  constant  throughout  the  year. 


INVESTED  CAPITAL  ACCOUNTING  183 

The  Harrison  Manufacturing  Co. 

BALANCE  SHEET 
as  at  December  31,  1919 

Assets  Liabilities  and  Capital 

Plant   $250,000    Bonds    $200,000 

Patents    75,000   Reserve  for  Depreciation    25,000 

Liberty  Bonds 75,000    Capital    Stock 325,000 

Pa.  Railroad  Stock 25,000    Surplus   300,000 

Pa.  Railroad  Bonds 75,000 

Municipal  Bonds 5"0,000 

Edison  Co.  Stock 25,000 

War    Finance     Corpora- 
tion Bonds 20,000 

Real  Estate 80,000 

Treasury   Stock 25,000 

Goodwill    150,000 


$850,000 


$850,000 


(1) — Referring  to  the  sub-division  just  given — we  find 
that  all  of  the  stock  was  issued  July  12,  1916,  at  par  value. 
We  find  that  the  treasury  stock  was  purchased  at  par. 
Also,  it  is  found  that  the  patents  were  acquired  for  cash, 
and  that  stock  was  issued  for  the  goodwill  which  was 
valuable. 

Adjusted  Balance  Sheet 
Assets  Liabilities  and  Capital 

Plant $250,000  Bonds    $200,000 

Less  Deprecia-  Capital  Stock. $325,000 

tion 25,000     $225,000       Less:  Treasury 

Stock 25,000       300,000 

Patents   75,000 

Liberty  Bonds 75,000   Surplus   225,000 

Pa.  R.  R.  Stock 25,000 

Edison  Company  Stock. .  25,000 

Pa.  R.  R.  Bonds 75,000 

Municipal  Bonds 5*0,000 

War  Fin.  Corp.  Bonds. .  20,000 

Real  Estate 80,000 

Goodwill    75,000 


$725,000 


$725,000 


184  INVESTED  CAPITAL  ACCOUNTING 

(2)  Inadmissibles — 

Pa.  Railroad  Stock $25,000 

Municipal  Bonds 50,000 

War  Finance  Corporation  Bonds 5,000 

Edison  Company  Stock 25,000 

Total $105,000 

(3)  Total  assets,  $725,000  divided  into  total  inadmissibles  equals 
14.482%. 

(4)  Invested  capital  items — 

Capital   Stock $300,000 

Surplus 225,000 


$525,000x.l44828=:$76,034.70 

(5) 

$525,000— $76,034.70 = $448,965.30 = invested  capital. 


Read  Cumulative  Bulletin.    December,  1919,  page  276 — 
1-19-116. 


Formula  for  Operations  (3),  (4),  and  (5) 

The  inadmissibles  placed  over  the  total  of  inadmissibles 
and  admisslbles  times  the  invested  capital  items,  thus : 


$525,000— ^f^r^U $525,000 ^=$448,965.30  invested  capital. 
\  «p  l  ^0,000  / 


This  formula  is  to  be  preferred  to  the  first  method  of 
computation  for  the  reason  that  an  exact  answer  may  be 
more  readily  obtained.  In  the  first  instance,  unless  the 
percentage  rate  is  carried  out  to  at  least  eight  decimal 
points  the  answer  will  not  be  exact  to  a  cent. 


INVESTED  CAPITAL  ACCOUNTING  185 

Pro-Rating  (or  Averaging)  Inadmissibles 

Article  852  tells  us  how  to  average  the  inadmissibles 
held  during  the  taxable  year,  and  states  that  when  a  "sub- 
stantial change"  occurs,  the  inadmissibles  must  be  averaged 
as  at  the  exact  date  that  the  change  took  place. 

We  are  not  told,  however,  what  shall  be  regarded  as 
a  "substantial  change."  This  appears  to  be  left  to  the 
judgment  of  the  auditor,  and  the  procedure  to  be  applied 
in  any  given  instance  should  be  based  on  the  merits  of  each 
particular  case.  It  is  evident  that  a  change  that  would  be 
"substantial"  in  the  matter  of  a  small  corporation,  might 
be  negligible  in  the  case  of  a  large  corporation. 

In  the  problems  presented  in  this  chapter  we  shall 
assume  that  all  of  the  changes  in  inadmissibles  during  the 
taxable  period  are  "substantial"  changes. 

Assets  of  the  Union  Company,  as  at — 

Dec.  31, 1918  Dec.  31, 1919 

Cash    $50,000  $60,000 

Plant    150,000  260,000 

Chicago  City  Bonds 60,000  10,000 

Liberty  Bonds 30,000  30,000 

War  Finance  Corporation  Bonds 10,000  10,000 


$300,000  $370,000 


Of  the  Chicago  City  Bonds,  $50,000  were  sold  Decem- 
ber 2, 1919,  at  cost,  and  were  not  reinvested  in  inadmissibles. 

Solution 

It  should  be  clear  to  you  that  to  add  the  inadmissibles 
held  at  the  beginning  of  the  year  to  the  amount  held  at 
the  end  of  the  year  and  arriving  at  an  average  by  dividing 
by  two,  would  not  give  us  the  true  average  for  the  reason 


186  INVESTED  CAPITAL  ACCOUNTING 

that  the  change  took  place  so  near  the  end  of  the  period. 
To  average  them  in  that  manner  would  produce — 


Held  at  the  beginning  of  the  year $65,000 

Held  at  the  end  of  the  year 15,000 

2)  $80,000 
Average  ( ?)  thus  obtained $40,000 

Now  let  us  find  the  true  average.  Inadmissibles  to 
the  amount  of  $50,000  were  sold  December  2,  1919,  there- 
fore this  amount  was  inadmissible  for  335/365  of  a  year, 
or  an  average  amount  of  $45,890.41.  This  amount,  plus 
the  amount  of  inadmissibles  that  remained  constant  through- 
out the  period,  $10,000  Chicago  City  Bonds,  and  War 
Finance  Corporation  Bonds  to  the  amount  of  $5,000  is  the 
true  average  amount — 


Amount  Sold,  prorated $45,890.41 

Chicago  Bonds  (constant) 10,000.00 

War  Finance  Corporation  Bonds 5,000.00 


The  true  average  amount $60,890.41 

Proof 

Averaged  amount  of  inadmissibles $60,890.41 

Averaged  proceeds  of  the  sale;  that  is,  $50,000x 
30/365,  or 4,109.59 


Amount  of  inadmissibles  originally  held $65,000.00 


Had  there  been  no  inadmissibles  at  the  beginning  of 
the  period,  and  had  $50,000  worth  been  acquired  December 
2,  1919,  the  average  amount  of  inadmissibles  would  be 
$50,000x30/365,  or  $4,109.59 ;  in  other  words,  the  inadmissi- 
bles, when  purchased,  or  when  disposed  of,  during  the 


INVESTED  CAPITAL  ACCOUNTING  187 

period,  must  be  pro-rated  over  the  entire  year  on  the  basis 
of  the  length  of  time  they  were  held  by  the  corporation, 
in  order  to  arrive  at  the  true  average  amount  held. 

Sold  at  a  Profit  and  Other  Income  Received 

Now  turn  to  Article  817  and  study  it  carefully.  Let 
us  quote:  "Where  the  income  derived  from  inadmissibles 
consists  in  pwrt  of  profit  from  the  disposition  thereof, 
*  *  *  a  corresponding  part  of  the  capital  invested  in 
such  assets  shall  be  deemed  an  admissible  asset." 

We  shall  illustrate  this  Article  by  presenting  the  Bal- 
ance Sheets  of  the — 

Franklin  Manufacturing  Company 
aa  at  December  SI,  1918 

Assets  Liabilities  and  Capital 

Cash    $50,000   Notes   Payable $90,000 

Plant   200,000   Capital    Stock 400,000 

Inventory    100,000   Surplus  210,000 

Municipal  Bonds 100,000 

Swift  Stock 50,000 

State  of  Ohio  Bonds 100,000 

Pullman  Stock 100,000 


$700,000  $700,000 

AND— 

as  at  December  31, 1919 

Assets  Liabilities  and  Capital 

Cash   $85,000   Notes   Payable $80,000 

Plant   270,000   Capital  Stock 400,000 

Inventory    140,000    Surplus   210,000 

State  of  Ohio  Bonds 50,000    Undivided  Profits 65,000 

Liberty  Bonds 100,000 

Standard  Oil  Stock 60,000 

Harvester  Stock 50,000 


$755,000  $755,000 


188  INVESTED  CAPITAL  ACCOUNTING 

The  Solution 

Remember,  one  thing  at  a  time,  is  our  slogan. 

(a)  We  find  that  the  municipal  bonds,  amounting  to 
$100,000,  were  sold  May  1,  at  a  profit  of  $3,000,  and  that 
interest  on  these  bonds,  amounting  to  $2,000  was  received 
just  prior  to  the  sale. 

Formula :  Profit  on  sale $3,000 

Interest  received 2,000 

Total  income $5,000 

Profit    $3,000 

—3/5 

Income  $5,000 

The  profit  bears  the  same  relation  to  the  total  income 
as  three  bears  to  five :  hence — 

3/5  of  $100,000=$60,000,  the  amount  that  becomes 
admissible  from  January  1  to  the  date  of  the  sale.  This 
leaves  $40,000  inadmissible  for  the  same  length  of  time 
—120  days. 

120/365x$40,000=$13,150.68,  the  average  amount  of 
this  inadmissible  carried  for  the  taxable  period. 

Since  the  proceeds  were  not  reinvested  in  other  inad- 
missibles,  they  become  admissible  from  May  1  to  December 
31.  The  proceeds  amount  to  $105,000.  The  sale  restored 
$60,000  to  admissibles,  leaving  $45,000  to  be  pro-rated  as 
at  May  1  to  December  31. 

$45,000x245/365=$30,205.48. 

Proof 

Restored  by  sale  at  a  profit $60,000.00 

Averaged   (admissible)   proceeds 30,205.48 

Inadmissibles  averaged  over  the  period 13,150.68 


Total  averaged  amount  of  this  asset $103,356.16 


INVESTED  CAPITAL  ACCOUNTING  189 

This  produces  a  larger  asset  amount  than  we  began 
with,  due  to  the  (averaged)  addition  of  the  $5,000  profit 
and  other  income.  If  we  average  (or  pro-rate)  the  $5,000 
separately  and  deduct  the  result  from  the  above  total  aver- 
aged amount  of  the  asset,  the  remainder  should  equal  the 
amount  that  we  started  out  with ;  namely,  $100,000. 

$5,000x245/365=$3,356.16 
$103,356.16— $3,356.16 = $100,000  the  original  amount. 

(b)  The  Swift  stock,  we  find,  was  sold  at  a  profit  of 
$2,000  and  no  other  income  was  received  from  this  source; 
hence,  the  entire  amount,  $50,000,  becomes  admissible  from 
January  1  up  to  the  date  of  the  sale,  June  29,  1919. 

Note  that  Article  817  states:  "Where  the  income 
*  *  *  consists  in  part  *  *  *  ."  Under  (a)  only  a 
part  of  the  income  was  taxable — a  3/5  portion;  therefore, 
only  3/5  was  restored.  In  this  instance,  all  of  the  income 
is  taxable ;  hence,  the  entire  amount  of  the  holding  becomes 
admissible  up  to  the  date  of  the  sale. 


Profit  on  sale $2,000 

Other    income 0,000 

Total    income $2,000 

$2,000  profit  over 

x$50,000= $50,000,  the  amount  to  be  restored 
$2,000  total  income 

for  a  period  of  180  days. 

This  asset  and  its  proceeds  would  have  been  deemed 
admissible  for  the  entire  year,  but  for  the  fact  that  $50,000 
of  the  proceeds  were  immediately  reinvested  in  Harvester 
Stock — another  inadmissible. 

So  now  we  have  $50,OOOxl80/365=$24,657.53,  the  aver- 
age admissible  portion,  and — 


190  INVESTED  CAPITAL  ACCOUNTING 

$50,OOOxl85/365=$25,342.47,  the  averaged  inadmissi- 
ble portion. 

Of  course,  the  profit  in  the  transaction,  $2,000  is  ad- 
missible, since  it  was  not  reinvested  in  inadmissibles.  It 
is  too  small  an  amount  to  pro-rate,  coming  as  it  does,  so 
near  to  the  middle  of  the  year.  See  the  sub-head  "Proceeds" 
appearing  near  the  close  of  this  chapter. 

Note:  You  will  have  observed  that  we  are  averaging 
these  changes  as  at  the  exact  date  of  occurrence.  In  the 
problem  presented  in  Article  817,  the  computation  is  not 
fully  carried  out.  See  Article  852,  llth  line,  which  directs: 
"  *  *  *  the  effect  of  such  change  shall  be  averaged 
exactly  from  the  date  on  which  it  occurred." 

(c)  The  State  of  Ohio  bonds,  to  the  amount  of  $50,000 
sold  for  $54,000,  August  1,  1919.  Interest  amounting  to 
$4,000  was  received  just  prior  to  the  sale.  The  receipts 
were  not  reinvested  in  inadmissibles. 

Profit  on  the  sale $4,000 

Interest    received 4,000 

Total   income $8,000 

Profit  to  total  income  is  as  4  to  8,  or  one-half.  One- 
half  the  holdings  became  admissible  up  to  the  date  of  the 
sale;  $50,000x212/365=$29,041.09,  average  amount  re- 
stored. 

Total  holdings  at  beginning  of  the  period $100,000 

Amount  remaining  constant $50,000.00 

Amount  restored  for  212/365  years 29,041.09 

Receipts  $58,000x153/365  years 24,312.33 


$103,353.42 
Now  if  we  deduct  from  this  amount  the  $8,000  interest 


INVESTED  CAPITAL  ACCOUNTING  191 

and  profit  received,  averaged  for  153/365  of  a  year,  we 
should  arrive  at  the  original  holding  of  $100,000,  which  will 
prove  the  correctness  of  our  computations. 

$8,000x153/365=43,353.42. 

(d)  On  November  3,  1919,  the  Pullman  stock  was  sold 
at  cost  and  immediately  reinvested  in  Liberty  bonds — an 
admissible  asset. 


$100,000x305/365  =  average   inadmissible $83,561.64 

$100,000x60/365  =  average  admissible 16,438.36 


These  two  amounts  added  equal  the  original  holdings  and 

prove  our  computation $100,000.00 


(e)  The  Standard  Oil  stock  was  purchased  December  2,  1919. 

$60,000x30/365    $4,931.51 

The  $60,000  used  to  purchase  this  stock  was  admissible 
for  335/365  of  a  year,  or 55,068.49 


Total  amount  involved $60,000.00 

THE  AVERAGED  BALANCE  SHEET 

It  should  be  clear  to  you  that  to  add  to  the  admissibles 
held  at  the  beginning  of  the  period  the  admissibles  held 
at  the  end  of  the  period  and  divide  by  two,  and  then  to 
this  amount  add  the  averaged  amounts  of  admissibles 
already  obtained  (some  disposition  must  be  made  of  those 
figures)  would  be  entirely  wrong.  It  would,  in  reality,  be 
equivalent  to  averaging  some  of  the  items  twice,  and  upon 
different  bases.  To  overcome  this  difficulty  we  have  evolved 
the  following — 

Rule  for  Averaging  the  Balance  Sheet 

To  the  sum  of  the  averaged  inadmissibles  add  the  sum 
of  the  previously-averaged  admissibles.  Deduct  this  total 


192  INVESTED  CAPITAL  ACCOUNTING 

from  the  balance  sheet  totals  as  at  the  beginning  of  the 
period  and  as  at  the  end  of  the  period.  Add  the  remainders 
and  divide  by  two.  This  will  average  all  that  have  not 
been  previously  averaged.  To  the  quotient  obtained  by 
dividing  by  two,  add  the  sum  of  the  previously-averaged 
admissibles  (those  that  were  involved  in  the  changes) .  The 
total  will  be  the  average  admissibles  for  the  period.  We 
already  have  the  average  of  the  inadmissibles  for  the 
period. 


Illustrating  the  Rule  by  Our  Problem 

Admissible  Inadmissible 

(a)  Municipal  bonds  restoration $60,000.00 

The  pro-rated  proceeds 30,205.48 

Pro-rated  inadmissible  portion $13,150.68 

(b)  Swift  Stock  (including  Harvester) 24,657.53       25,342.47 

(c)  Ohio  bonds,  constant  portion 50,000.00 

Restored  by  sale  at  a  profit 29,041.09 

Pro-rated  receipts 24,312.33 

(d)  Pullman  stock 16,438.36       83,561.64 

(e)  Standard    Oil — admissible    portion    in- 
volved     55,068.49 

Inadmissible  portion 4,931.51 


$239,723.28  $176,986.30 

Balance  sheet  totals —  at  beginning    at  end  of  period 

$700,000.00          $755,000.00 
Less  the  total  of  the  above 

sums:  that  is $239,723.28 

plus    $176,986.30  416,709.58  416,709.58 


$283,290.42          $338,290.42 
Added  and  averaged 338,290.42 

2)621,580.84 

$310,790.42  =the  average  of 

the  assets  not  entering  into  any  of  the  transactions  involving  inad- 
missibles. 


INVESTED  CAPITAL  ACCOUNTING  193 

To  this  we  must  add  the  average  of  the  affected  ad- 
missibles  and  the  affected  inadmissibles — 


Above  average  brought  down $310,790.42 

Average  admissibles  as  above 239,723.28 


Total  average  admissibles $550,513.70 

Total  average  inadmissibles 176,986.30 


Average  of  all  assets $727,500.00 


Now,  while  this  result  is  just  the  same  as  we  would 
have  obtained  (proving  the  correctness  of  our  computa- 
tions) had  we  averaged  the  sum  of  the  total  assets  held 
at  the  beginning  of  the  period  and  at  the  end  of  the  period, 
the  component  parts  (that  is,  part  one,  admissibles;  part 
two,  inadmissibles)  are  much  different,  as  we  shall  show — 


Inadmissibles  at  the  beginning $350,000 

Inadmissibles  at  the  end 160,000 


2)  $510,000 

False  average  of  inadmissibles $255,000 

Admissibles  at  the  beginning $350,000 

Admissibles  at  the  end 595,000 


2)945,000 
False  average  of  admissibles $472,500 


The  invested  capital  items  amount  to  $610,000.  Assum- 
ing that  the  1918  income  tax  paid  in  1919  amounts  to 
$100,000,  and  reducing  surplus  by  .422603  of  this  amount, 
leaves  a  net  invested  capital  (provided  no  inadmissibles 
had  been  carried)  of  $567,739.70.  Since  inadmissibles  were 


194  INVESTED  CAPITAL  ACCOUNTING 

carried,  this  amount  must  be  further  reduced  in  accordance 
with  Article  854,  beginning  with  line  13.  (See  formula 
given  previously  in  this  chapter.) 

/  $176,986.30  \ 

$567,739.70— (  *       5QQ  QQ  x  $567,739.70  J  =$429,619.91. 

which  gives  us  the  net  amount  of  invested  capital. 

Inadmissibles  Sold  at  a  Loss 

In  the  event  that  an  inadmissible  is  sold  at  a  loss,  the 
asset  would  be  inadmissible  up  to  the  date  of  the  sale,  and 
the  proceeds,  if  not  reinvested  in  inadmissibles,  would  be 
admissible  from  the  date  of  sale  up  to  the  end  of  the  tax- 
able period. 

If  the  proceeds,  on  the  same  day,  were  reinvested  in 
inadmissibles,  the  amount  reinvested  would  be  inadmissible 
from  the  date  of  the  sale  up  to  the  end  of  the  period.  In 
arriving  at  the  average  amount,  it  is  not  necessary  to  pro- 
rate both  the  asset  sold  and  the  asset  acquired.  Simply 
pro-rate  the  amount  of  the  loss,  or  the  difference  between 
the  amount  originally  carried  and  the  amount  carried  after 
the  sale  and  the  reinvestment. 

To  illustrate:  The  Morgan  Stove  Company  carried 
municipal  bonds  amounting  to  $50,000,  as  at  the  beginning 
of  the  year.  May  1  the  bonds  were  sold  for  $45,000  and 
the  proceeds  were  reinvested  in  Coppers. 

It  is  evident  that  $45,000  of  the  assets  were  inadmissi- 
ble for  the  entire  period,  and,  in  addition,  $5,000  would  be 
inadmissible  for  120  days ;  that  is,  up  to  the  date  of  the  sale 
of  the  municipal  bonds. 

120/365x$5,000=$l,643.84. 

To  this  amount  add  the  constant  amount,  and  we  have 
a  total  of  $46,643.84,  the  average  amount  of  this  inadmissi- 
ble for  the  period. 


INVESTED  CAPITAL  ACCOUNTING  195 

Inadmissibles  Exchanged  for  Admissibles 

A  transaction  of  this  nature  should  be  treated  pre- 
cisely as  we  treat  a  sale  of  inadmissibles ;  that  is,  the  hold- 
ing is  inadmissible  up  to  the  date  of  the  exchange,  and  the 
asset  received  for  it  (in  other  words,  the  proceeds,  received 
in  the  form  of  property)  is  admissible  from  the  date  of 
the  exchange  up  to  the  end  of  the  period. 

Should  an  inadmissible  be  exchanged  for  an  intangible, 
the  procedure  would  be  just  the  same  as  if  the  intangible 
had  been  purchased  for  cash — in  other  words,  it  would  be 
includable  in  invested  capital  at  the  full  value  given  in 
exchange  for  it,  and  would  not  come  within  the  25% 
limitation. 

Stock  Held  in  Foreign  Corporations 

Many  domestic  corporations  hold  stock  in  foreign  cor- 
porations. Sometimes  this  stock  might  be  admissible  and 
sometimes  it  might  be  inadmissible,  dependent  upon  the  fol- 
lowing conditions: 

(a)  If  the  foreign  corporation  receives  income  from 
sources  within  the  United  States,  then  whatever  amount  of 
its  stock  that  is  held  by  a  domestic  corporation  is  inadmissi- 
ble.   See  April,  1920,  Digest  (No.  9),  page  189,  24-19-576. 

(b)  If  the  foreign  corporation  does  not  receive  income 
from  sources  within    the  United    States,  then  whatever 
amount  of  its  stock  that  is  held  by  a  domestic  corporation 
is  admissible.    For  example,  take  the  case  of  the — 

Barnes  Manufacturing  Company 

BALANCE  SHEET 
as  at  December  31,  1919 
Assets  Liabilities  and  Capital 

Cash    $60,000   Notes  Payable $90,000 

Vera  Cruz  Oil  Stock 75,000    Capital    Stock 200,000 

London  Tramway  Stock. .  75,000   Surplus   210,000 

Sundry  Assets 290,000 


$5-00,000  $500,000 


196  INVESTED  CAPITAL  ACCOUNTING 

Upon  investigation  it  is  learned  that  the  Vera  Cruz 
Oil  Company  receives  income  from  sources  within  the 
United  States;  hence,  any  of  its  stock  that  is  held  by  a 
domestic  corporation  is  an  inadmissible  asset. 

It  is  found  that  the  London  Tramway  Company  does 
not  derive  income  from  sources  within  the  United  States, 
therefore,  any  of  its  stock  that  is  held  by  a  domestic  cor- 
poration is  an  admissible  asset. 

The  reason  for  this  is  to  be  found  in  our  general  rule 
for  determining  the  status  of  any  asset,  as  stated  on  a 
preceding  page,  under  the  caption,  "The  Dividing  Line." 
The  income  received  by  a  domestic  corporation  from  stock 
held  in  the  Vera  Cruz  Company  would  not  be  taxed,  because 
the  income  that  the  Vera  Cruz  Company  received  from 
sources  within  the  United  States  has  been  taxed  in  the 
hands  of  the  Vera  Cruz  Company,  or  in  the  hands  of  its 
agents  in  the  United  States. 

In  the  matter  of  the  London  Tramway  Company,  the 
income  received  on  stock  held  by  a  domestic  corporation 
would  be  taxable  for  the  reason  that  it  had  not  previously 
been  taxed  by  the  United  States  Government. 

Organization  Expenses,  Etc. 

Inasmuch  as  organization  expenses,  amounts  expended 
for  the  development  of  patents  (which  have  not  been  made 
a  charge  against  net  income) ,  or  to  protect  title  to  property, 
and  similar  items,  are  not  embraced  in  the  list  of  inadmissi- 
bles  previously  given  in  this  lecture,  they  must  be  given 
the  status  of  admissible  assets. 

The  question  is  often  asked,  whether  or  not  organiza- 
tion expenses  should  be  included  in  invested  capital.  To 
find  an  answer  to  this  question  it  is  only  necessary  to  answer 
another  question:  Do  we  allow  organization  expenses  as  a 
deduction  from  gross  income  at  deriving  at  net  taxable 


INVESTED  CAPITAL  ACCOUNTING  197 

income  for  any  period?  We  do  not.  Hence  it  follows  that 
organization  expenses,  since  they  are  not  a  deduction,  must 
be  included  in  invested  capital  to  the  extent  that  they  have 
not  been  amortized.  It  is  good  accounting  practice,  of 
course,  to  amortize  organization  expenses  over  a  short 
period  of  years,  say  three  to  five  years,  and  this  course 
is  followed  by  many  corporations  so  that  sooner  or  later 
all  such  expenses  disappear  as  invested  capital  and  have 
been  charged  off  through  Surplus.  Note,  however,  that  if 
the  corporation  has  made  these  expenses  a  charge  to  Profit 
and  Loss,  thereby  reducing  net  income,  the  amount  charged 
off  must  be  restored  to  net  income  precisely  as  we  would 
restore  a  donation  that  had  been  charged  to  Profit  and  Loss. 

It  would  seem  only  fair  dealing  to  restore  to  invested 
capital  any  legitimate  amount  of  organization  expenses  that 
had  previously  been  charged  off,  either  through  Profit  and 
Loss  or  through  Surplus.  This  harks  back  to  our  previous 
statement:  An  item  must  either  be  allowed  as  a  deduction 
or  it  must  be  included  in  invested  capital. 


Status  of  Inadmissibles  Held  by  Trustee 

Let  us  assume  that  the  X  Corporation  is  required  to 
establish  a  Sinking  Fund  for  the  redemption  of  bonds,  or 
for  any  other  purpose,  and  that  this  Sinking  Fund  must 
be  placed  in  the  hands  of  a  trustee,  as  is  quite  customary. 
The  corporation  turns  over  the  fund  in  the  form  of  cash 
to  the  trustee.  The  cash  is,  of  course,  an  admissible  asset. 
The  trustee  takes  the  cash  and  invests  it  in  Municipal 
Bonds.  Here  is  a  condition  that  has  been  the  cause  of  con- 
siderable confusion  in  the  minds  of  many  auditors — the 
status  of  these  bonds.  It  is  contended  by  some  that  inas- 
much as  the  corporation  placed  cash  in  the  hands  of  a 
trustee  (and  some  cite  the  fact  that  the  trustee  might  be 
a  bank)  that  the  asset  represented  by  the  fund  would  be 
regarded  as  an  admissible  asset  of  the  corporation.  This 


198  INVESTED  CAPITAL  ACCOUNTING 

is  an  incorrect  view  as  will  be  apparent  when  it  is  understood 
that  the  trustee  is  merely  acting  as  the  agent  of  the  corpora- 
tion. Any  asset  he  holds  must  be  given  the  same  status  that 
that  asset  or  a  similar  asset  would  be  given  if  held  by  the 
corporation. 

"Proceeds" 

A  good  many  auditors  have  contended  that  the  word 
"proceeds"  as  used  in  Article  817,  Regulations  45,  does 
not  contemplate  the  inclusion  of  the  profit  made  in  the 
sale  of  an  inadmissible — that  the  word  means  only  the 
amount  derived  from  the  sale  which  represents  the  return 
of  investment.  It  is  difficult  to  see  how  any  one  who  knows 
the  meaning  of  the  word  "proceeds"  could  take  such  a  posi- 
tion, but  since  many  do,  it  is  felt  that  attention  should  be 
called  to  the  matter.  "Proceeds"  means  that  which  is 
received  in  return  for  something — the  total  amount  of  it, 
whether  it  be  profit  or  whether  it  be  original  investment. 
If  a  concern  sells  stock  for  $1,000  that  cost  $900,  the  pro- 
ceeds of  that  sale  are  $1,000  and  are  made  up  of  the  original 
$900  investment  and  the  $100  profit. 

Dealers  in  Securities 

Stocks,  Municipal  Bonds  and  other  inadmissible  assets, 
when  held  by  a  dealer  in  securities,  are  inadmissible  not- 
withstanding the  fact  that  they  might  embrace  the  total 
assets  of  the  concern.  Of  course,  when  any  of  such  hold- 
ings are  sold  by  the  concern  at  a  profit  we  would  restore 
to  admissibles  the  same  proportion  of  the  asset  as  we  would 
were  it  held  by  an  industrial  concern.  Some  are  inclined 
to  think  that  this  is  not  fair — that  in  the  case  of  a  dealer 
in  securities  inadmissibles  held  comprise  the  concern's  in- 
ventory and  should  have  the  same  status  that  would  be 
given  an  inventory  of  a  mercantile  concern.  The  law  makes 
no  exceptions;  Article  817  makes  no  exceptions,  and  the 


INVESTED  CAPITAL  ACCOUNTING  199 

only  thing  left  for  the  auditor  to  do  is  to  be  guided  by  the 
law  and  Regulations. 


Cardinal  Points 

The  thing  to  be  determined  is :  Is  the  income  (interest 
or  dividends)  that  the  corporation  received  or  might  have 
received  from  an  asset  taxable?  If  it  is  not,  the  asset  is 
inadmissible. 

The  only  income  received  or  receivable  on  an  asset 
that  renders  it  inadmissible  is  non-taxable  INTEREST  or 
non-taxable  DIVIDENDS. 

Industrial  bonds  are  admissible  assets. 

This  chapter  defines  the  treatment  of  inadmissibles  as 
required  by  the  1918  Act.  Do  not  attempt  to  apply  the 
same  method  of  treatment  to  inadmissibles  reported  in  a 
1917  return.  There  is  no  similarity  in  the  two  methods 
of  treatment. 

Inadmissible  assets  sold  at  a  profit  renders  a  portion 
of  the  asset  (and,  perhaps  all  of  it)  admissible. 

When  adjusting  a  balance  sheet,  consider  only  one 
thing  at  a  time. 


An  Intentional  Omission — Not  an  Oversight 

Article  817,  (b),  has  something  to  say  about  restoring 
inadmissibles  by  reason  of  the  non-deductibility  of  certain 
interest  paid. 

Some  of  the  best  accountants  in  America  have  labored 
with  this  subject,  only  finally  to  admit  that  they  do  not 
know  what  is  the  correct  procedure.  The  writer  of  this 
book  dares  not  venture  in  where  angels  fear  to  tread. 


200  INVESTED  CAPITAL  ACCOUNTING 

Further,  the  writer  does  not  believe  you  will  ever  have 
occasion  to  make  use  of  this  portion  of  the  law.  At  any 
rate,  you  will  have  no  need  to  until  such  time  as  some 
corporation  is  found  that  is  honest  enough  to  tell  us  that 
it  borrowed  certain  money  with  which  to  purchase  an  in- 
admissible. We  know  of  no  other  way  of  finding  out  that 
there  was  "interest  incurred  or  continued  to  purchase  or 
carry"  an  inadmissible.  You  can't  "tag"  a  dollar. 


CHAPTER  ELEVEN 
DEPRECIATION— OBSOLESCENCE— .APPRECIATION 

Definitions 

The  effect  on  net  income  of  the  functioning  of  depre- 
ciation, depletion,  and  obsolescence  is  identical,  in  that  any 
one  of  them,  when  allowable,  reduces  the  taxable  income, 
but  this  is  the  only  instance  in  which  they  harmonize. 
The  meanings  of  the  terms  differ  greatly,  and  so  do  the 
reasons  for  allowing  a  deduction  from  gross  income  when 
any  one  of  these  factors  is  to  be  considered. 

(a)  Depreciation  is  the  result  of  the  action  of  the 
natural  law  of  wear  and  decay  upon  all  things  made  by 
man  and  is  based  on  the  usable  life  of  the  asset.    Depre- 
ciation applies,  also,  to  some  things  not  artificial  (as  live 
stock  purchased,  if  not  purchased  for  resale).    The  actual 
effect  of  depreciation  is  to  reduce  the  value  of  that  which 
remains. 

A  building  is  erected  at  a  cost  of  $10,000.  At  the 
moment  of  completion  it  is  worth  that,  and  its  pre- 
sumptive life  is  twenty  years.  At  once  deterioration 
enters  into  every  piece  of  material  in  the  structure; 
that  is,  it  is  depreciating.  At  the  end  of  one  year  one- 
twentieth  of  the  value  has  vanished — it  is  worth  but 
$9,500 — that  is  the  value  that  remains.  The  same  thing 
takes  place  the  second  year,  and  so  until  the  structure 
has  ceased  to  be  usable. 

(b)  Depletion  has  no  effect  upon  the  value  of  that 
which  remains  (unless  it  be  to  increase  that  value  by  les- 


202  INVESTED  CAPITAL  ACCOUNTING 

sening  the  available  supply).  Depletion  represents  the 
amount  by  which  the  volume  is  reduced  in  quantity  units. 
It  operates  only  upon  natural  resources,  such  as  coal,  or 
timber,  and  on  nothing  made  by  man. 

Jones  buys  a  vein  of  coal.  It  contains,  according 
to  competent  engineers,  100,000  tons.  The  coal  does 
not  depreciate,  but  any  amount  of  coal  removed  from 
the  mine  depletes  it  to  the  extent  of  the  removal.  If 
10,000  tons  are  removed  the  first  year,  the  mine  has 
suffered  depletion  to  that  extent  and  if  the  unit  cost 
is,  let  us  say,  20  cents  a  ton,  the  depletion  in  dollars 
amounts  to  $2,000,  and  Jones'  books  should  show  a  de- 
pletion valuation  account  of  $2,000  in  one  of  two  ways — 


First: 

Assets  Liabilities  and  Net  Worth 

Mine    $20,000   Notes  Payable $6,000 

Less  Reserve  for  Deple-  Capital  Stock 12,000 

tion 2,000 


$18,000  $18,000 


Second : 

Assets  Liabilities  and  Net  Worth 

Mine $20,000    Notes   Payable $6,000 

Reserve  for  Depletion 2,000 

Capital  Stock 12,000 


$20,000  $20,000 


(c)    Obsolescence,  generally,  is  applied  to  things  made 
by  man,  and  is  based,  not  on  the  number  of  years  that  the 


INVESTED  CAPITAL  ACCOUNTING  203 

asset  may  be  usable,  but  on  the  period  of  time  that  it  is 
found  to  be  not  useful  for  the  purpose  for  which  the  asset 
was  intended.  Avoid  the  dictionary  definitions  of  these 
three  terms — they  may  confuse  you,  and  they  are  of  no  aid 
to  you  in  income  tax  work. 

Smith  has  certain  gear-cutting  machines.  They  are 
in  splendid  condition  and  will  do  perfectly  the  work  for 
which  they  were  bought.  Brown  is  a  competitor  of 
Smith.  He  acquires  a  newly-invented  machine  that 
will  do  as  good  work  as  the  Smith  machines,  but  at  a 
greatly  reduced  cost.  Smith  can  no  longer  compete 
with  Brown  unless  he,  also,  installs  the  improved  ma- 
chines, which  he  does.  His  older  machines  have  not 
depreciated  to  such  an  extent  as  to  render  them  value- 
less, but  they,  through  the  introduction  of  improved 
machines,  have  become  obsolete,  hence  he  can  change 
off  as  obsolescence  (provided  he  discards  the  old  ma- 
chines) the  cost  of  the  older  machines  less  the  depre- 
ciation already  charged  off  and  less  any  salvage  value 
they  may  have. 

The  operation  of  all  three  of  these  income-reducing 
factors  may  be  illustrated,  compared,  and  contrasted  in  the 
following  abridged  statement  of  a  case: 

The  Hobart  Mining  Company  began  operations  Jan- 
uary 1,  1918.  Lot  "A"  of  the  machinery  cost  $30,000,  and 
lot  "B"  cost  $22,000;  all  machinery  having  a  five-year  life. 

Competent  mining  engineers  estimated  that  the  con- 
tent of  the  mine  was  1,000,000  units;  the  cost  per  unit, 
ten  cents. 

In  1918,  50,000  units  were  removed.  This  is  the  amount 
of  depletion;  that  is,  the  mine  has  been  depleted  to  the 
extent  of  6%  of  the  amount  it  originally  contained.  Since 
the  unit  cost  was  ten  cents,  it  is  evident  that  the  depletion 


204  INVESTED  CAPITAL  ACCOUNTING 

value  is  $5,000,  and  this  is  the  amount  that  the  company 
may  deduct  from  gross  income,  as  representing,  not  profit, 
but  the  return  of  $5,000  of  its  capital.  If  this  return  should 
be  distributed  to  the  shareholders  the  invested  capital  of 
the  company  would  be  reduced  by  a  like  amount,  pro-rated 
as  at  the  date  of  distribution. 

On  December  31,  1918,  20%  of  the  cost  of  the  ma- 
chinery was  charged  to  depreciation.  The  machines  are 
not  depleted — they  are  partly  worn  out — they  have  depre- 
ciated in  value.  If  we  did  not  permit  the  company  to  deduct 
this  amount  in  arriving  at  net  income,  we  would  be  taxing 
the  capital  of  the  company  in  an  amount  equal  to  the  amount 
of  depreciation. 

On  June  30,  1919,  lot  "B"  of  the  machinery  equipment 
is  found  to  be  no  longer  adapted  to  the  work  of  this  mine, 
or  it  may  be  scrapped  for  some  other  equally  good  reason; 
there  may  be  machines  on  the  market  that  will  do  more 
work  in  the  same  length  of  time,  or  the  same  amount  of 
work  with  less  operatives,  etc.  The  company  decides  to 
install  new  machines,  more  suited  to  the  work.  Here  is 
where  obsolescence  comes  in.  The  old  machines  are  sold 
to  another  concern  engaged  in  mining  of  a  different  nature. 
The  sale  price  is  $8,000,  and  the  loss  is  chargeable  to 
obsolescence.  How  much  is  the  loss?  Is  it  $14,000?  Let 
us  see — 


Cost  of  lot  "B" $22,000 

Capital  returned  by  depreciation.  .$6,600 
Capital  returned  by  sale 8,000 

Total  amount  of  capital  returned . .  14,600 


Deductible  loss  for  1919 . .  $7,400 


INVESTED  CAPITAL  ACCOUNTING  205 

Why  Depreciation? 

For  a  concern  (or  an  individual)  to  pay  out  the  appar- 
ent earnings  without  making  sufficient  allowance  for  depre- 
ciation, would  be  equivalent  to  liquidation  of  capital.  It 
is  conceivable  that  such  a  procedure  might  be  continued 
year  after  year  until  such  time  as  the  plant  and  equipment 
were  worn  out,  with  nothing  on  hand  with  which  to  replace 
them — all  of  the  original  investment  having  gone  out  in 
the  form  of  dividends. 

The  object  of  computing  depreciation,  with  regard  to 
income  tax,  is  to  give  to  the  taxpayer  such  a  portion  of  his 
gross  income  as  shall  reimburse,  or  return  to  him,  such 
an  amount  of  the  original  investment  as  may  have  disap- 
peared by  reason  of  wear  and  decay  of  his  equipment  or 
other  depreciable  asset. 

The  wear  and  decay  (usually  called  "wear  and  tear") 
may  not  always  be  apparent,  but  it  is  present.  Purchase 
a  new  hat  today.  Tomorrow  it  will  appear  to  be  precisely 
as  good  as  it  did  the  moment  you  purchased  it.  On  the 
third  day  you  will  see  no  difference  between  its  appearance 
then  and  its  appearance  on  the  second  day.  But  IS  it  the 
same?  It  is  not.  If  it  were  it  would  last  forever.  Every 
moment  of  time  from  the  moment  you  purchased  it  it  is 
becoming  of  less  value — its  period  of  usefulness  is  becom- 
ing shorter,  until  finally  it  must  be  discarded. 

And  so  it  is  with  many  of  the  assets  of  the  taxpayer. 
Each  moment  of  time  they  are  of  less  value  than  at  any 
preceding  moment.  Like  the  hat,  this  lessening  of  value 
is  usually  not  apparent.  This  fact  must  be  faced — ALL 
PROPERTY  IS  DETERIORATING  at  a  more  or  less  rapid 
rate.  Some  critics,  having  a  hobby  for  precision  of  state- 
ment, might  say  that  this  assertion  is  too  broad,  and  might 
cite  money  and  land  as  exceptions.  Not  catering  to  the 
idiosyncrasies  of  hobbyists,  we  will  not  discuss  this  point 
here. 


206  INVESTED  CAPITAL  ACCOUNTING 

But  do  not  be  misled.  When  we  state  that  all  property 
is  deteriorating  we  do  not  mean  to  say  that  depreciation  is 
allowable  on  all  property,  for  such  is  not  the  case. 

Bear  in  mind  that  depreciation  must  be  provided  for 
before  net  profits  can  be  ascertained  just  as  surely  as  that 
cost  of  labor,  or  of  supplies,  must  be  considered. 

There  can  be  no  profits  until  all  expenses  are  taken 
care  of  and  depreciation  is  as  certainly  an  item  of  expense 
as  are  light  and  heat,  or  rent  and  insurance.  It  may  be 
a  little  difficult  to  see  that  depreciation  is  an  expense  owing 
to  the  fact  that  actual  money  is  not  being  paid  out  month 
by  month  or  at  other  stated  periods  of  time. 

Suppose  we  put  it  in  this  light:  John  Adams  goes 
into  the  furniture  manufacturing  business.  He  buys  from 
Uriah  Morse  a  machine  called  a  "shaper."  It  cost  $1,000 
in  cash.  Morse  tells  Adams  that  the  shaper  will  last  just 
ten  years,  and  Adams,  being  a  practical  mill  man,  knows 
this  statement  to  be  true. 

Morse  proposes  that  if  Adams  will  give  him  $100  each 
year  (disregarding,  for  the  moment,  the  compounding  of 
interest)  for  ten  years  that  at  the  beginning  of  the  eleventh 
year  he  will  give  Adams  a  new  shaper  of  the  same  model 
as  the  old  one. 

Don't  you  think  that  Adams,  when  he  is  paying  out 
these  hundred  dollar  amounts,  would  fully  realize  that  de- 
preciation is  an  expense?  He  would  know  that  he  was 
giving  Morse  the  money  for  the  purpose  of  placing  his  shop, 
at  the  end  of  ten  years,  in  just  the  same  state  of  efficiency 
as  when  he  began  business  and  that  during  the  ten-year 
period  he  had  suffered  an  expense  of  exactly  one  thousand 
dollars  in  the  wear  of  machinery;  that  a  little  portion  of 
that  value  had  gone  into  each  piece  of  wood  he  had  shaped 
— kept  on  going  until  no  value  remained. 


INVESTED  CAPITAL  ACCOUNTING  207 

Let  us  illustrate  it  this  way :  Adams  purchased  a  large 
quantity  of  lumber  and  stacked  it  in  one  pile.  The  first 
thing  he  made  was  a  table.  Wishing  to  know  at  what  price 
he  must  sell  tables  in  order  to  make  a  profit,  he  set  down 
cost  items;  labor,  rent,  power,  varnish,  etc.  Not  knowing 
the  exact  amount  of  lumber  used,  he  glanced  at  his  lumber 
pile  and  thought:  "The  pile  appears  to  be  as  big  as  it 
was  before  I  made  the  table;  "I'll  not  consider  the  cost  of 
the  lumber."  Would  such  procedure  be  business-like?  Of 
course  it  would  not,  but  it  would  be  just  as  reasonable  as 
it  would  be  for  him  to  glance  at  the  shaper  and  say,  "I 
can  see  no  wear;  it's  as  good  as  new,  therefore  I  will  not 
consider  depreciation." 


Methods  of  Computing  Depreciation 

There  are  seven  or  eight  methods  of  computing  depre- 
ciation. The  Regulations  do  not  require  any  particular 
plan,  but  leave  it  optional  with  the  taxpayer,  so  long  as  the 
method  adopted  is  a  recognized  one  and  is  explained  in  the 
return  of  the  taxpayer.  See  Article  165. 

Of  the  several  methods  in  use,  only  two  receive  much 
consideration  outside  of  text  books.  These  two  are  the 
"Straight-Line  Method,"  and  the  "Declining  Value  Method." 

Of  these  two,  the  first-named  is  used  much  more  fre- 
quently than  the  other,  due  perhaps,  to  the  complexity  of 
the  computation  required  in  following  the  second  method. 

Of  the  other  methods,  as  the  Annuity  Method,  the 
Revaluation  Method,  Composite  Life  Method,  etc.,  nothing 
need  be  said,  as  it  is  unlikely  that  you  will  ever  have  occa- 
sion to  use  any  of  them  unless  you  should  follow  the  pro- 
fession of  public  accounting. 


208  INVESTED  CAPITAL  ACCOUNTING 

The  Straight-Line  Method 

This  method  consists  simply  of  dividing  $1  by  the 
probable  number  of  years*  life  of  the  asset  to  obtain  the 
rate  of  percentage  to  deduct  from  the  cost  of  the  asset  at 
the  end  of  each  accounting  period.  Or  (and  this  amounts 
to  the  same  thing)  dividing  the  cost  by  the  number  of 
years,  to  find  out  the  lump  amount  to  allow  for  depreciation 
at  the  end  of  each  period. 

To  illustrate:  A  new  stamping  machine  is  bought  at 
a  cost  of  $6,000,  and  it  has  an  estimated  life  of  twelve 
years.  One  dollar  divided  by  12  gives  a  percentage  of 
8  1/3.  Multiplying  $6,000  by  this  percentage  gives  us  $500 
as  the  amount  of  yearly  depreciation.  Or,  the  other  way: 
$6,000  divided  by  12  gives  us  the  same  amount — $500. 

Sometimes  this  method  is  modified  so  as  to  provide 
a  more  equitable  distribution  of  the  (depreciation)  expense, 
in  cases  where  the  residual,  or  scrap  value,  is  fairly  ascer- 
tainable.  Thus,  a  concern  purchases  a  new  machine  at  a 
cost  of  $7,700  cash.  Experience  has  taught  that  this  ma- 
chine should  last  16  years,  and  at  the  end  of  that  time  the 
machine  will  have  a  salvage  value  of  $500. 

If  depreciation  is  based  on  a  cost  of  $7,700  and  this 
amount  is  charged  off,  and  later  $500  is  realized  on  the 
residual,  it  should  be  clear  that  here  is,  in  effect,  a  double 
return  of  capital  investment  to  the  amount  of  $500.  If, 
on  the  other  hand,  no  depreciation  were  charged  off  for 
the  last  year,  the  profit  reflected  by  the  Profit  and  Loss 
Statement  would  be  inflated  by  $500,  or  the  books  would 
have  to  be  "juggled"  to  reflect  the  true  profit  for  the 
period. 

To  overcome  this  objectional  feature,  the  residual  value 
is  deducted  from  the  cost  price  and  the  remainder  is  the 
basis  or  amount  that  is  distributed  over  the  life  of  the 
asset  in  way  of  depreciation.  Seven  thousand  and  two  hun- 


INVESTED  CAPITAL  ACCOUNTING  209 

dred  dollars  divided  by  16  gives  $450,  the  amount  to  be 
charged  to  depreciation  at  the  end  of  each  accounting 
period.  Algebraically  it  would  be  expressed  thus : 


in  which  D  indicates  the  annual  depreciation, 

V  represents  the  cost  or  value,  R  indicates  the  residual,  and 
Y  the  number  of  years  of  life. 


Unequal  Percentage  Method 

This  is  another  name  for  the  "Straight-Line  Method/' 
A  property  valued  at  $1,000,  life  ten  years,  is  depreciated, 
let  us  say,  at  the  rate  of  ten  per  centum  on  the  cost.  This 
is  an  unequal  percentage  method,  notwithstanding  the  fact 
that  we  use  ten  per  centum  each  period.  The  first  year 
the  depreciation  is  $100,  or  10%  of  $1,000.  The  second 
year  it  is  another  $100,  but  the  value  of  the  property  is 
now  only  $900,  so  that  $100  depreciation  on  a  value  of 
$900  is  a  trifle  more  than  11%.  This  rate  would  increase 
as  the  years  went  on.  The  equal  percentage  method  is  to 
be  found  in  the  Declining  Method,  mentioned  previously. 
By  this  method  we  must  ascertain  that  percentage,  which 
when  applied  to  the  declined  value  of  each  year,  will  render, 
at  the  end  of  the  life  of  the  asset,  a  return  of  capital  that 
shall  equal  the  cost  less  the  residual  or  salvage  value. 

The  Declining  Value  (or  Fixed  Percentage)  Method — 

is  a  much  more  complicated  scheme  than  the  Straight- 
Line  Method.  It  is  sufficient  for  the  purpose  in  hand  simply 
to  illustrate  its  application.  As  to  how  the  rate  of  depre- 
ciation is  obtained,  you  are  referred  to  your  old-time 
logarithmic  days  and  the  tables  you  pored  over  at  that 
time. 


210  INVESTED  CAPITAL  ACCOUNTING 

Proposition : 

A  certain  piece  of  machinery  cost  $1,000.  It  is  esti- 
mated that  the  machine  will  last  five  years,  and  that  the 
residual  value  will  be  $200.  By  the  use  of  logarithms  we 
find  the  depreciation  rate  to  be  27%%.  The  following  table 
gives  the  amount  of  depreciation  to  be  charged  oif  at  the 
end  of  each  year  to  leave  a  residual  of  $200: 


Value  as  at  Depreciation 

Year                         January  1  for  the  year 

1    $1,000.00  $275.00 

2    725.00  199.38 

3    525.62  144.54 

4    381.08  104.80 

5  .                                276.28  75.98 


Total  charged  off $799.70 

Cost,  $1,000,  less  $799.70  charged  off,  gives  a  salvage 
amount  to  be  realized  of  $200.30.  Had  the  decimals  been 
carried  out  far  enough  the  last-named  figure  would  have 
been  $200  within  a  fraction  of  a  cent.  A  few  cents,  in  such 
a  case,  is  immaterial — whether  the  amount  be  a  little  more 
or  a  little  less  than  the  amount  of  residual  originally 
estimated. 

You  will  note  that,  theoretically,  where  there  is  no 
residual  value,  as  in  a  franchise,  or  a  lease,  this  method 
can  not  be  employed  unless  a  fictitious  or  nominal  value 
is  set  up,  as  one  cent,  or  one  dollar  to  act  as  the  residual- 
value  element  in  the  formula. 

Percentage  of  Depreciation 

It  is  not  possible  to  furnish  a  schedule  of  rates  of 
depreciation  that  can  be  applied  to  all  cases,  or  even  to  a 
majority  of  cases.  An  occasional  asset  item  may  be  found 


INVESTED  CAPITAL  ACCOUNTING  211 

for  which  a  standard  percentage  rate  can  be  named,  as 
in  the  case  of  furniture  and  fixtures,  which  is  usually  placed 
at  ten  per  centum,  but  even  the  percentage  rate  in  this 
instance  may  vary.  I  have  seen  a  rate  as  high  as  twenty 
and  one  as  low  as  five,  and  in  those  particular  cases,  the 
rate  claimed  was  considered  equitable. 

Many  items  vary  greatly  in  the  rate  of  allowance.  Some 
kinds  of  machinery  may  have  useful  lives  of  only  four  or 
five  years,  while  other  machines  may  be  expected  to  last 
for  a  period  of  twenty  or  more  years.  Some  tools  and 
equipment  may  last  for  twenty  or  more  years;  others  for 
only  a  few  years  or  a  few  months.  Where  the  useful  life 
is  only  a  matter  of  a  few  weeks  or  months,  or  even  one 
year,  they  would,  of  course,  be  chargeable  to  current  ex- 
pense, for  the  result  would  be  the  same  were  they  to  be 
capitalized  and  depreciated. 

A  printing  concern  may  have  presses  that  will  last 
30  years,  composing  sticks  and  galleys  (barring  obsolescence, 
of  course)  should  last  many  years,  while  type,  if  it  be 
given  reasonably  constant  use,  will  do  well  if  it  lasts  four 
years. 

Tools  used  in  cabinet  work  ought  to  last  from  ten 
to  twenty  years  while  painters'  tools  may  last  but  a  few 
months  or  weeks.  I  have  in  mind  an  actual  case:  A 
plastering  corporation  in  its  return  deducted  50  per  centum 
depreciation  on  its  equipment  of  ladders,  scaffolding, 
trowels,  hoes,  hods,  etc.  An  agent  was  asked  to  investigate. 
The  result  was  that  he  allowed  all  that  was  claimed.  If 
you  will  think  a  moment  you  will  see  that  he  was  right 
in  so  doing. 

The  life-years  given  in  the  following  table  should  be 
regarded  as  only  suggestive.  For  the  percentage  rate  in 
any  given  case,  divide  $1  by  the  number  of  years  of  life. 
It  may  be  that  some  of  the  percentages  would  be  applicable 


212  INVESTED  CAPITAL  ACCOUNTING 

to  the  usual  run  of  cases,  but  in  each  individual  case  the 
auditor  must  exercise  care  and  judge  each  case  on  its  merits 
for  so  many  factors  enter  into  the  question  of  deprecia- 
tion that  a  rate  which  would  be  fair  for  one  concern  might 
be  unjust  for  the  next. 


Item  Life-years 

Furniture  and  Fixtures 10 

Frame  buildings  (temporary  buildings,  but  a  few  years)  .20  to  40 

Brick  buildings .30  to  50 

Concrete  buildings 50  to  75 

Concrete- Steel  buildings 75  to  100 

Real  estate  (apart  from  improvements)  NO  DEPRECIATION 
ALLOWED. 

Woodworking  machinery,  printing  machinery,  and  machinery 
used  in  light  manufacturing,  any  life  period  ranging  from 
10  to  25  years. 

Heavy  machinery,  such  as  concrete  mixers,  stone  crushers,  stamp- 
ing machines,  mine  machinery,  punching  and  die  cutting 
machines,  machines  used  in  steel  mills  and  the  larger  ma- 
chine shops,  etc.,  has  a  life  of  from  5  to  10  years. 

Machines  of  precision,  such  as  those  used  in  the  manufacture  of 
watches;  the  various  glasses,  astronomical  and  others; 
chronometers,  optical  instruments,  drafting  tools,  surgical 
instruments,  etc.,  while  they  may  have  a  long  life,  they 
are  apt  at  any  day  to  become  useless,  either  from  obsoles- 
cence or  due  to  the  fact  that  they  no  longer  are  capable  of 
turning  out  accurate  product. 

The  period  of  usefulness  of  automobiles,  motorcycles,  bicycles, 
trucks,  delivery  wagons,  and  other  conveyances  is  short — 
usually  about  five  years. 

The  life  of  water  craft  is  longer  than  the  life  of  conveyances 
used  on  land  and  the  depreciation  rate  is  usually  low.  See 
Bulletin  9-20,  page  14. 


INVESTED  CAPITAL  ACCOUNTING  213 

Depreciation  Must  Be  Charged  Off 

In  order  for  the  taxpayer  to  take  advantage  of  a  deduc- 
tion for  depreciation,  the  depreciation  must  be  charged  off. 
The  specific  manner  in  which  this  is  to  be  done  is  left  to 
the  taxpayer.  The  following  Balance  Sheets  illustrate  the 
two  methods  mentioned  in  Article  169  (which  see). 


Assets  Liabilities  and  Capital 

Cash    $50,000   Capital    Stock $150,000 

Receivables    50,000   Allowance   for   Deprecia- 

Plant   150,000       tion   15,000 

Surplus  85,000 


$250,000  $250,000 

OR— 

Assets  Liabilities  and  Capital 

Cash $50,000    Capital  Stock $150,000 

Receivables 50,000   Surplus   85,000 

Plant $150,000 

Dess  Deprecia- 
tion        15,000      135,000 


$235,000  $235,000 


To  obtain  the  true  value  of  the  assets  by  the  first 
method  given  above,  the  Valuation  Account  (Allowance  for 
Depreciation)  must  be  deducted  from  the  asset  total.  In 
the  second  method,  the  Balance  Sheet  shows  at  a  glance  the 
true  value  of  the  assets. 

Depreciation  and  Repairs 

Ordinary  repairs  are  a  deductible  expense  item  and 
are  allowable  in  addition  to  the  depreciation  deduction.  But 
a  distinction  must  be  made  between  what  are  clearly  repairs 


214  INVESTED  CAPITAL  ACCOUNTING 

necessary  to  keep  the  machine  in  an  efficient,  running  con- 
dition and  repairs  (really  improvements)  which  appreciably 
prolong  the  life  of  the  machine.  The  latter  items  must 
be  classified  as  capital  expenditures,  and  are  not  deductible 
items,  but  they  are,  of  course,  depreciable  over  subsequent 
periods.  Take  the  case  of  an  automobile;  a  new  set  of 
spark  plugs  would  be  considered  as  repairs,  and  be  de- 
ductible as  expense,  while  the  installation  of  a  new  engine 
would  have  the  effect  of  making  an  almost  new  machine 
out  of  an  old  one,  and  should  be  classed  as  a  capital  expendi- 
ture. See  Article  103. 

Discarded  Property — Illustrated 

During  January,  1920,  the  Reliance  Machine  Company 
discarded  machines  that  cost,  in  January,  1914,  $15,000. 
The  company  had  charged  off  depreciation  during  this  period 
to  the  amount  of  $7,500,  which  was  the  correct  amount. 
The  discarded  machines  were  sold  for  $1,500.  The  return 
of  capital  amounts  to  the  sum  of  the  depreciation  charged 
off  plus  the  salvage  value,  or  a  total  return  of  $9,000.  How 
shall  the  company  proceed  to  secure  the  return  of  the  re- 
mainder of  its  investment  in  these  machines  without  being 
taxed  on  this  amount?  The  answer  is:  It  may  deduct, 
as  a  loss,  in  its  return  for  1920,  the  unreturned  amount 
—$6,000. 

In  January,  1920,  the  Everett  Cotton  Mills  discarded 
looms  for  which  the  corporation  paid  $15,000  in  January, 
1914.  No  depreciation  had  ever  been  taken  in  its  tax 
returns  and  none  had  ever  been  charged  off.  The  looms 
were  sold  as  junk  and  $1,000  was  realized  on  the  lot.  May 
it  take  a  loss  of  $14,000  in  its  1920  income  tax  return?  No. 
It  may  deduct  the  difference  between  the  amount  of  depre- 
ciation that  should  have  been  charged  off  PLUS  the  salvage 
value,  and  the  cost  price.  We  will  assume  that  the  machines 
would  have  had  a  normal  life  of  ten  years — depreciation 
rate 


INVESTED  CAPITAL  ACCOUNTING  215 

6  years  x  10% =60% 

60%x$15,000=: $9,000 

Salvage  value 1,000 

Capital  returned $10,000 

Cost    15,000 

Loss  deductible  in  tax  return  for  1920 $5,000 


As  to  how  the  taxpayer  may  recoup  for  the  deprecia- 
tion not  charged  off  during  prior  years,  see  Digest  for  April, 
1920,  page  83 ;  30-19-639,  S.  1217.  Also,  see  Article  1561. 

Extraordinary  Depreciation 

The  Atlas  Woodworking  Company  was  a  manufacturer 
of  light  cabinet  work.  Its  machines,  when  used  for  that 
purpose,  had  a  probable  life  of  twenty  years.  Deprecia- 
tion had  always  been  charged  off  on  that  basis.  In  1918, 
finding  business  falling  off,  it  began  the  manufacture  of 
large  refrigerators  and  other  heavy  woodwork — things  that 
should  have  been  made  on  heavier  and  stronger  machines. 

Had  the  company  so  desired,  it  could  have  scrapped 
the  machines  and  deducted  as  obsolescence  the  difference 
between  the  amount  of  depreciation  already  charged  off 
and  the  original  cost  of  the  machines,  LESS  salvage  value. 
It  did  not  feel  financially  able  (this  particular  reason  is 
no  determining  factor — any  reason  causing  the  company 
to  take  such  action  would  "get  by")  to  purchase  a  new 
outfit  of  heavier  machines,  so  it  continued  to  use  the  old 
ones,  thereby  imposing  on  the  machines  stress  and  strain 
in  excess  of  the  amount  they  were  intended  to  withstand. 

May  this  concern,  from  the  date  on  which  the  machines 
were  put  to  this  new  line  of  work,  deduct  a  rate  of  depre- 
ciation greater  than  had  been  taken  previously  ?  Yes.  See 
Digest,  April,  1920,  page  90,  16-20-862. 


216  INVESTED  CAPITAL  ACCOUNTING 

Almost  the  same  condition  would  obtain  where  ma- 
chines are  run  continuously.  When  it  is  stated  that  a 
machine  has  a  life  of  fifteen  years,  it  is  meant  that  under 
ordinary  working  conditions,  of,  let  us  say,  eight  hours  a 
day,  that  the  machines  should  last  for  fifteen  years. 

If  machines  are  run  for  twenty-four  hours  a  day  it 
is  evident  that  they  will  not  last  fifteen  years.  It  would 
not  follow,  however,  that  we  should  reduce  the  probable 
life  to  five  years,  for  machines  that  are  working  only  eight 
hours  a  day  are  depreciating  at  a  more  or  less  rapid  rate 
during  the  sixteen  hours  of  idleness,  but  probably  not  as 
rapid  a  rate  as  when  running.  In  this  instance  we  prob- 
ably should  give  the  machines  a  depreciable  life  of  ten 
years. 


A  Profit  in  Place  of  a  Loss 

It  sometimes  happens  that  a  taxpayer  will  claim  a  loss 
in  the  sale  of  property  when,  in  actuality,  a  profit  has  been 
earned. 

The  Jewel  Cutlery  Company  paid  $10,000  for  a  parcel 
of  real  estate.  In  July,  1914,  it  erected  a  building  thereon 
at  a  cost  of  $80,000.  The  life  of  the  building  is  placed  at 
fifty  years.  In  January,  1919,  the  property  was  sold  for 
$85,000,  and  the  company  claimed  a  deductible  loss  of  $5,000 
in  its  1919  income  tax  return.  Should  this  deduction  be 
allowed  ?  Let  us  see — 


Property  sold  for $85,000 

Depreciation  on  building  for  4  Ms  years 7,200 

Amount  of  capital  returned $92,200 

Cost  of  property 90,000 


Taxable  income $2,200 


INVESTED  CAPITAL  ACCOUNTING  217 

Replacement  Value  and  Depreciation 

In  its  1917  return  the  Columbia  Corporation  deducted 
$3,500  depreciation  on  its  seven  crimping  machines.  The 
machines  were  purchased  in  1915  and  were  supposed  to 
last  for  ten  years.  During  1918  it  became  necessary  to 
purchase  four  additional  (and  identical)  machines.  Owing 
to  the  great  advance  in  the  cost  of  machinery  of  all  kinds, 
the  company  was  required  to  pay  $33,600  for  the  new 
machines. 

In  its  return  for  1919  the  company  deducted  $9,240  for 
depreciation  on  the  eleven  machines,  on  the  basis  that  the 
replacement  value  of  the  seven  machines  is  the  same  per 
machine  as  the  cost  of  the  new  machines.  Is  this  amount 
of  deduction  allowable?  NO.  The  two  fundamental  facts 
to  be  ascertained  in  computing  depreciation  are — 

(a)  The  cost  of  the  asset  if  acquired  subsequent  to 
March  1,  1913,  or,  if  acquired  prior  to  that  date, 
its  value  as  at  March  1,  1913. 

(b)  The  probable  life  of  the  asset  (based,  where  pos- 
sible, on  experience). 

A  third,  but  less  important  factor,  might  be  men- 
tioned— that  of  ascertaining  the  residual  or  salvage 
value. 

What  it  might  cost  to  replace  an  asset  now  is  not 
indicative  of  what  it  may  cost  in  the  future.  See  April, 
1920,  Digest,  page  90,  0.  D.  283. 

In  the  case  cited  above,  the  company  must  depreciate 
the  seven  original  machines  on  the  basis  of  the  cost  of 
the  seven  and,  in  the  case  of  the  new  machines,  it  must 
compute  depreciation  on  the  basis  of  the  cost  of  the  four. 

Amount  Recoverable  Through  Depreciation 

The  total  amount  of  depreciation  that  a  taxpayer  may 
deduct  over-  the  life  period  of  an  asset  is  the  capital  sum 


218  INVESTED  CAPITAL  ACCOUNTING 

invested  in  the  asset  if  acquired  subsequent  to  March  1, 
1913,  or  the  value  of  the  asset  as  at  March  1,  1913,  if 
acquired  prior  to  that  date,  less  the  salvage  value,  if  any. 

LAND,  apart  from  any  improvements  that  may  have 
been  placed  upon  it,  is  NOT  SUBJECT  TO  DEPRECIA- 
TION. Article  164  is  very  clearly  stated  and  should  be 
given  careful  study. 

Reserve  for  Depreciation 

Very  frequently  you  will  find  on  Balance  Sheets  the 
so-called  Reserve  for  Depreciation.  As  stated  in  Chapter 
Eight,  such  a  reserve  can  not  be  included  in  invested  cap- 
ital. Of  course,  if  the  reserve  represents  an  amount  in 
excess  of  the  true  depreciation,  the  excess  of  the  reserve 
over  the  correct  amount  of  depreciation  should  be  included 
in  invested  capital. 

Intangible  Property  and  Depreciation 

If  Davis  procures  a  copyright  direct  from  the  govern- 
ment, his  invested  capital,  in  so  far  as  the  copyright  is 
a  contributing  factor,  is  the  fee  he  paid  the  government, 
plus  any  attorney  fees  that  may  have  been  necessary,  plus 
amounts  expended  for  typists,  or  other  clerical  or  profes- 
sional aid,  and  any  other  legitimate  expenses  in  connection 
therewith,  and  which  were  not  charged  or  chargeable  to 
current  expenses. 

If  Davis  purchased  a  copyright  from  another,  his  in- 
vested capital  in  the  copyright  is  the  amount  he  paid  for  it. 

In  either  of  the  above  events,  if  Davis  found  it  neces- 
sary to  defend  his  title  to  the  copyright,  whatever  outlay 
was  necessary  in  the  litigation  would  be  a  part  of,  or  an 
addition  to,  his  capital  invested  in  the  copyright.  Arti- 
cle 293. 


INVESTED  CAPITAL  ACCOUNTING  219 

The  amount  of  capital  invested  in  the  copyright  is 
the  amount  that  may  be  the  subject  of  depreciation,  divided 
by  the  number  of  years  of  life  of  the  copyright  that  are 
unexpired  at  the  time  of  its  acquisition  by  Davis. 

If,  during  the  legal  life  of  the  copyright,  it  becomes 
evident  that  it  no  longer  has  value,  due  to  supersession, 
or  to  other  legitimate  reason,  then  the  difference  between 
the  amount  of  depreciation  already  charged  off  and  the 
amount  invested  in  the  copyright  would  be  an  allowable 
deduction  as  obsolescence. 

Article  163,  as  given  in  the  1920  edition  of  Regula- 
tions 45,  has  been  amended  by  the  elimination  of  the  last 
sentence:  "There  can  be  no  such  allowance  in  respect  of 
goodwill,  trade  names,  trade-marks,  trade  brands,  secret 
formulae,  or  processes."  This  change  makes  the  Regula- 
tions harmonize  with  the  ruling  given  at  the  bottom  of 
page  88  of  the  April,  1920,  Digest.  You  are  urged  to  study 
this  ruling.  As  it  is  very  concisely,  as  well  as  clearly  stated, 
it  seems  unnecessary  to  add  anything  here  by  way  of  ex- 
planation. Also,  study  T.  B.  M.  39,  Cumulative  Bulletin, 
page  131.  See  Articles  167  and  170. 

Patents 

The  conditions  that  apply  to  copyrights  are  also  appli- 
cable to  patents  with  the  exception  that  it  is  not  obligatory 
on  the  part  of  the  taxpayer  to  charge  off  depreciation  on 
patents.  Make  a  close  study  of  Article  843. 

Depreciation  of  patents  (as  well  as  other  depreciable 
property)  acquired  prior  to  March  1,  1913,  should  be  based 
on  the  value  established  as  at  that  date.  Do  not  permit 
this  statement  to  lead  you  to  allow  the  value  as  at  March 
1,  1913,  to  be  included  in  invested  capital.  The  cost  of 
the  patent  (or  other  property)  is  the  amount  allowable. 


220  INVESTED  CAPITAL  ACCOUNTING 

THE  VALUE  OF  AN  ASSET  AS  AT  MARCH  1,  1913, 
HAS  NO  BEARING  ON  INVESTED  CAPITAL,  if  such 
value  is  different  from  the  cost.  Cost,  and  only  COST,  is 
the  determining  factor  in  the  computation  of  invested 
capital. 


A  Peculiar  Condition  or  Result 

Computing  depreciation  on  the  value  as  at  March  1, 
1913,  sometimes  leads  to  a  singular  condition,  in  that  more 
depreciation  may  be  charged  off  than  the  concern  has  in- 
vested in  an  asset,  as  you  will  note  from  the  following : 

The  Sherwood  Company  purchased  a  patent  in  March, 
1908,  at  a  cost  of  $17,000.  Inasmuch  as  a  patent  runs  for 
17  years,  the  depreciation  charged  off  each  year  amounted 
to  $1,000. 

This  patent  proved  to  be  very  valuable  and  at  March 
1,  1913,  it  was  revalued  at  $120,000.  From  that  date  the 
patent  had  a  life  of  twelve  years,  and  depreciation  was 
rightfully  taken  at  the  rate  of  $10,000  a  year.  You  will 
at  once  see  that  in  less  than  two  years  more  depreciation 
was  charged  off  than  the  company  had  invested  in  the 
patent. 


Realization  of  Appreciation 

Take  the  last  proposition  presented — that  of  the  re- 
valued patent.  Had  the  patent  not  been  revalued  the  com- 
pany would  have  charged  off  the  books,  up  to  January  1, 
1918,  depreciation  amounting  to  $9,833.33.  On  the  basis 
of  the  revaluation,  depreciation  was  charged  off  over  the 
period  from  March  1,  1913,  to  January  1,  1918,  amounting 
to  $48,333.33.  Add  to  this  the  amount  charged  off  during 
the  first  five  years  and  we  have  a  total  of  $53,333.33.  Thus 
we  have — 


INVESTED  CAPITAL  ACCOUNTING  221 

Charged  off  on  revaluation  basis  and  prior  years $53,333.33 

Amount  that  would  have  been  charged  off  had  there  been  no 

revaluation 9,833.33 


Difference $43,500.00 


This  difference  represents  realization  of  appreciation, 
and,  if  not  distributed  and  is  in  use  in  the  business,  it  may 
be  added  to  invested  capital.  See  Article  844  (c) . 

Two  things  should  be  noted  in  this  connection — 

(a)  This  is  the  only  instance  where  any  semblance  of 
appreciation  may  be  included  in  invested  capital, 
and  it  has  led    many  auditors    to  conclude  that 
appreciation  has  been  added  to  invested  capital. 
Such  is  not  the  case.    No  appreciation  can  in  any 
case  be  included  in  invested  capital.    In  the  instant 
illustration  there  is  none  added. 

It  is  true  that  we  actually  are  adding  back  an 
amount  greater  than  the  original  cost  of  the  pat- 
ent, but  note — we  are  not  adding  a  cent  to  the 
patent;  what  we  are  doing  is  to  add  back  to  SUR- 
PLUS an  amount  that  actually  had  been  charged 
against  Surplus  periodically  through  Profit  and 
Loss  in  excess  of  the  amount  that  invested  capital 
values  permitted.  Had  such  additional  charges 
not  been  made,  profits  would  have  been  larger, 
and,  if  not  distributed,  Surplus  would  have  been 
an  equal  amount  greater. 

(b)  The  revaluation  must  have  been  made  as  at  March 
1,  1913.    Should  it  have  been  made  at  any  other 
date,  and  should  the  taxpayer  report  the  enhanced 
value  as  income  and  pay  taxes  thereon,  the  appre- 
ciation can  not  be  included  in  invested  capital.    The 
government  will  not  accept,  or,  will  not  retain, 


INVESTED  CAPITAL  ACCOUNTING 

any  taxes  paid  on  this  fictitious  income.    See  Digest 
for  April,  1920,  page  196,  7-19-308,  T.  B.  M.  41. 

There  is  another  date  for  ascertaining  fair  market 
value,  but  it  has  to  do  entirely  with  natural  resources. 

Depreciation  of  Models 

The  Stokes  Typewriter  Company,  during  1919,  ex- 
pended $20,000  in  having  drawings,  models,  etc.,  made  in 
an  effort  to  improve  its  machine.  Is  this  expense  or  is  it 
capital  expenditure  and  subject  to  depreciation? 

The  company  may  exercise  the  privilege  of  charging 
this  amount  to  expense,  or,  it  may  set  up  the  amount  as 
a  capital  investment  and  depreciate  it  over  the  estimated 
period  of  usefulness  of  the  several  items.  See  Article  168. 

Obsolescence  of  Buildings 

One  of  the  activities  of  the  Penn  Realty  Company  was 
the  erection  of  an  apartment  house  in  what  was  then  a 
very  desirable  residential  district.  It  cost,  January,  1914, 
$80,000.  It  was  let  to  a  very  desirable  class  of  high-rent- 
paying  tenants.  In  December,  1917,  a  factory  was  erected 
across  the  street  from  these  apartments,  and  as  a  result, 
all  of  the  tenants  vacated  as  soon  as  the  leases  expired. 

To  avoid  having  an  empty  building  on  its  hands  the 
company  found  it  necessary  to  fill  it  with  factory  employees 
at  a  low  rental.  The  effect  of  this  was  to  cause  the  building 
to  be  run>  at  a  loss  in  1919. 

The  company  claims  that  the  building  is  obsolescent 
and  in  its  1919  return  makes  a  large  deduction  for  this 
reason. 

Is  this  allowable?  No.  The  building  is  still  usable 
for  tenant  purposes  and  that  is  the  purpose  for  which  it 


INVESTED  CAPITAL  ACCOUNTING  223 

was  built,  and  no  deductions  are  allowable  except  depre- 
ciation, ordinary  repairs,  and  the  loss  sustained  in  the 
operation  of  the  building. 

On  the  other  hand,  if  the  company  had  been  aware, 
in  December,  1918,  let  us  say,  that  the  locality  was  to 
become  undesirable  as  tenant-rental  property,  and  had  it 
determined,  that  in  January,  1921  (or  at  any  other  date), 
the  building  should  be  torn  down,  it  could  deduct 
obsolescence  for  the  years  1918,  1919,  and  1920,  on  the 
following  basis : 


Cost    $80,000 

Depreciation  for  5  years  at  3% $12,000 

Estimated   residual   value 8,000 

Total  return   .  20,000 


Obsolescence $60,000 

The  amount  of  obsolescence  should  be  spread  equally 
over  the  three-year  period  and  $20,000  deducted  each  year. 
See  Bulletin  4-20-704,  O.  D.  381. 

Appreciation  Must  Be  Placed  Where  It  Belongs 

It  is  possible,  though,  perhaps,  not  probable,  that  the 
appreciation  of  the  land  would  not  be  at  the  same  rate  as 
the  appreciation  of  the  improvements,  or  vice  versa.  Other- 
wise, of  course,  the  rate  of  appreciation  would  be  equal. 
The  following  propositions  illustrate  the  amount  of  taxable 
income  to  be  returned  in  two  similar,  yet  dissimilar,  cases 
— one  in  which  the  land  appreciated  and  the  building  did 
not;  the  other,  a  case  in  which  both  appreciated  ratably. 

The  cost,  March  1,  1908,  was,  land,  $100,000 ;  building, 
$100,000.  Life  of  building,  40  years. 


224  INVESTED  CAPITAL  ACCOUNTING 

Revalued  as  at  March  1, 1913 — 
Proposition  "A" 

Land    $200,000 

Building 87,500 


Total  value  March  1,  1913 $287,500 


Note  that  the  value  of  the  building  is  placed  at  its 
original  cost,  less  regular  depreciation. 


Proposition  "B" 

Land $150,000 

Building    137,500 


Total  value  March  1,  1913 $287,500 


Note  that  both  properties,  as  a  whole,  have  the  same 
value  at  the  beginning  as  well  as  at  the  date  of  revaluation, 
and  observe  how  this  inequality  in  the  rate  of  appreciation 
will  affect  the  taxable  income. 

March  1,  1918,  both  properties  were  sold  for  $300,000 
each.  What  is  the  taxable  income  in  each  instance  ? 

Under  Proposition  "A" — 

Sale   price $300,000.00 

Five  years'  depreciation  on  the  original  cost 12,500.00 


Amount  of  capital  returned $312,500.00 

Value  as  at  March  1,  1913 287,500.00 


Total  taxable  income $25,000.00 


INVESTED  CAPITAL  ACCOUNTING  225 

Under  Proposition  "B" — 

Sale   price $300,000.00 

Five  years'  depreciation  on  revaluation  as  at  March 

1,  1913 19,642.85 


$319,642.85 
Value  as  at  March  1,  1913 287,500.00 


Total  taxable  income $32,142.85 


It  should  be  noted  that  in  the  years  between  March 
1,  1913,  and  March  1,  1918,  the  corporation  would  be 
entitled  to  a  larger  deduction  for  depreciation  in  computing 
net  income  under  Proposition  "B"  than  it  would  be  under 
Proposition  "A" ;  therefore,  during  those  years  its  tax  under 
"B"  would  be  less  than  under  Proposition  "A"  provided, 
of  course,  that  the  gross  income  were  equal. 

Birthday  of  Income  Tax  Law 

You  will  have  observed  that  frequent  reference  has 
been  made  to  the  date,  March  1,  1913.  This  particular 
date  is  the  basis  of  many  computations  and  adjustments  for 
the  reason  that  it  is  the  Birthday  of  our  present  series  of 
income  tax  laws. 

The  law  of  1909  is  commonly  referred  to  as  an  income 
tax  law,  but  this  is  misleading.  It  was  an  excise  tax  law, 
and  perhaps  the  reason  for  its  being  called  an  income 
tax  law,  is  the  fact  that  the  excise  tax  was  based  upon 
income. 

Things  Worth  Remembering 

1.  Depreciation  is  an  almost  ever-present  item  of  ex- 
pense and  must  be  charged  off.  Net  income  can  not  be 


226  INVESTED  CAPITAL  ACCOUNTING 

determined  without  first  ascertaining  the  amount  of  depre- 
ciation expense. 

2.  The  amount  of  net  income  a  concern  may  report  is 
overstated  unless  it  has  charged  off  sufficient  depreciation 
for  the  period,  and,  conversely,  if  insufficient  depreciation 
has  been  charged  off  in  the  past,  invested  capital  is  over- 
stated. 

3.  The  basis  of  depreciation  is  the  cost  of  the  asset 
if  it  was  acquired  subsequent  to  March  1,  1913,  or  the 
value  of  the  asset  as  at  March  1,  1913,  if  acquired  prior 
to  that  date. 

4.  A  change  in  the  use  to  which  a  building  is  put, 
or  a  lessening  of  the  value  of  a  building  by  reason  of  a 
change  in  its  surroundings,  no  matter  what  the  cause  of 
the  change,  gives  no  basis  for  a  claim  for  deduction  for 
obsolescence. 

5.  Patents  may  be  depreciated,  or  they  may  not,  at 


the  option  of  the  taxpayer. 


6.  The  value  of  an  asset  as  at  March  1,  1913,  bears 
no  relation  to  the  amount  of  invested  capital  that  may  be 
allowable.  The  amount  a  corporation  paid  for  an  asset, 
less  the  subsequent  depreciation,  obsolescence,  or  depletion 
that  was  or  should  have  been  charged  off  is  the  amount 
that  may  be  included  in  invested  capital. 

7.  A  "Reserve  for  Depreciation"  is  not  a  true  reserve 
— it  is  not  allocated  surplus — and  can  not  be  included  in 
invested  capital.    See  Article  1549. 

8.  Depreciation  does  not  apply  to  inventories;  neither 
does  it  apply  to  natural  resources.    See  Article  162. 

9.  The  total   amount  of    depreciation  that  may  be 
charged  off  with  respect  to  a  depreciable  asset,  is  the  cost 
of  the  asset  if  acquired  subsequent  to  March  1,  1913,  or 


INVESTED  CAPITAL  ACCOUNTING  227 

the  value  of  the  asset  if  acquired  prior  to  that  date.  Hence, 
a  concern  that  has  depreciated  an  asset,  let  us  say  Furniture 
and  Fixtures,  for  a  period  of  ten  years  at  10%  a  year,  can- 
not claim  a  deduction  for  depreciation  of  this  asset  for  the 
eleventh  or  any  subsequent  year. 

10.  Appreciation,  except  to  the  extent  that  it  is  recog- 
nized in  the  revaluation  of  property  (that  has  increased  in 
value)  as  at  March  1,  1913,  is  an  unknown  and  unused 
quantity  in  income  tax  procedure.  The  allowing  of  revalua- 
tion of  natural  resources  under  certain  conditions  is,  strictly 
speaking,  not  appreciation,  for  the  value  was  there  before 
the  discovery,  but  partakes  more  of  the  nature  of  the  deter- 
mination of  the  amount  to  be  valued — not  re-valued. 

Look  Up  These  References: 

O.  D.  344,  and  0.  D.  472,  page  89,  Digest  for  April,  1920. 

Special  Observation.  Under  the  subheading,  "Intan- 
gible Property  and  Depreciation/'  is  a  statement  that  is 
at  variance  with  the  Recommendation  of  the  Committee 
on  Appeals  and  Review,  as  given  in  Bulletin  20-20-934. 
Article  293  states,  "The  cost  of  DEFENDING  or  perfecting 
title  *  *  *  ."  If  words  mean  anything,  the  statement 
of  the  writer  of  this  treatise  is  in  complete  harmony  with 
Regulations,  Article  293.  Note  that  Article  293  does  not 
differentiate  between  the  two  kinds  of  property — tangible 
and  intangible— it  says  PROPERTY. 


CHAPTER  TWELVE 
A.  R.  M.  106 

It  appears  that  the  Memorandum  from  the  Committee 
on  Appeals  and  Review,  commonly  known  as  A.  R.  M.  106, 
has  been  the  cause  of  a  great  deal  of  uncertainty  and 
misapprehension  in  the  minds  of  many  persons  in  the  In- 
come Tax  Unit. 

Just  why  this  should  be  so  it  is  difficult  to  under- 
stand. Various  individuals  have  had  all  sorts  of  ideas 
and  notions  concerning  it.  I  have  had  able  men  in  the 
audit  tell  me  that  under  A.  R.  M.  106  appreciation  must 
be  allowed  in  invested  capital.  I  have  been  told  that  tax- 
payers or  taxpayers'  representatives  in  conferences  have 
stood  up  and  shaken  their  fists,  pawed  the  air,  and  defied 
the  conferee  to  disallow  appreciation,  citing  as  their  Gibral- 
tar of  defense  A.  R.  M.  106.  I  have  had  able  auditors  tell 
me  in  class  that  A.  R.  M.  106  specifically  provides  for  the 
inclusion  of  appreciated  values  in  invested  capital  and  that 
they  could  show  it  to  me.  On  several  occasions  I  have 
passed  them  a  copy  of  the  memorandum  and  asked  them 
to  do  so.  Needless  to  say,  they  were  unable  to  do  it. 

All  of  us  are  prone  to  accept  a  thing  as  being  difficult 
or  ambiguous  or  incomprehensible  when  we  are  told  by  some 
one  in  whose  ability  we  have  confidence  that  such  a  one 
cannot  understand  a  given  statement.  I  believe  that  some- 
thing of  this  sort  has  been  the  cause  of  the  wave  of  uncer- 
tainty that  has  swept  over  the  Unit  regarding  A.  R.  M. 
106 — somebody  told  somebody  else  that  it  was  not  under- 
standable, and  that  assertion  was  repeated  on  down  the 


INVESTED  CAPITAL  ACCOUNTING  229 

line  until  the  rank  and  file  came  to  believe  it  to  be  a  fact, 
perhaps  not  taking  the  trouble  actually  to  read  it  and 
fewer  still  taking  the  trouble  to  read  it  carefully  and 
study  it. 

A.  R.  M.  106  did  not  change  the  Regulations  an  iota. 
It  only  emphasized  Article  839,  Regulations  45.  As  a  mat- 
ter of  fact,  there  is  quoted  in  the  memorandum,  as  a  jus- 
tification for  the  memorandum,  a  portion  of  Article  839. 

But  let  us  take  up  the  original  A.  R.  M.  106  and  analyze 
it  and  see  what  it  does  say.  (The  reference  remarks  em- 
bodied in  the  memorandum  are  interpolated  by  the  writer.) 

"The  Committee  is  in  receipt  of  a  memorandum  from 
the  Income  Tax  Unit  requesting  advice  relative  to  the  prac- 
tice of  field  agents  in  reducing  earned  surplus  by  deduc- 
tions for  depreciation  where  none  had  been  claimed  in  the 
past,  or  where  a  lower  rate  has  been  claimed  than  is  ordi- 
narily allowable  (a)  with  respect  to  the  depreciable  assets 
in  question. 

"It  is  the  judgment  of  the  Committee  that  there  is 
no  warrant  for  reducing  earned  surplus  because  of  alleged 
failure  (b)  to  charge  off  sufficient  depreciation  in  the  past, 
unless  the  depreciable  assets  of  the  corporation  are  valued 
on  its  books  at  the  beginning  of  the  taxable  year  at  an 
amount  in  excess  of  their  actual  value  (c)  at  that  time. 
This  is  particularly  true  where  the  corporation  in  prior 
years  earned  positive  income  from  which  larger  deductions 
for  depreciation  might  have  been  taken,  (d)  if  in  the  opinion 
of  the  officers  and  directors  of  the  corporation  such  larger 
charges  had  been  justified.  Nothing  herein  is  to  be  con- 
strued as  precluding  the  Income  Tax  Unit  from  adjusting 
(e)  depreciation,  either  by  way  of  increase  or  decrease, 
where  there  is  at  hand  affirmative  evidence  that  as  at  the 
beginning  of  a  taxable  year  the  amount  of  depreciation 
written  off  in  prior  years  was  insufficient  or  excessive.  The 


230  INVESTED  CAPITAL  ACCOUNTING 

correct  attitude  of  the  Bureau  and  the  proper  conduct 
of  its  field  agents,  in  particular,  are  plainly  set  forth  in 
that  part  of  Article  839  of  Regulations  45,  which  reads: 

"Adjustments  in  respect  of  depreciation  or 
depletion  in  prior  years  will  be  made  or  permitted 
only  upon  the  basis  of  affirmative  evidence  that  as 
at  the  beginning  of  the  taxable  year  the  amount 
of  depreciation  or  depletion  written  off  in  prior 
years  was  insufficient  or  excessive,  as  the  case 
may  be." 

(a)  "Ordinarily  Allowable."  In  my  view  that  is  the 
whole  "meat  in  the  cocoanut."  It  were  absurd  to  assume 
that  the  vast  majority  of  corporations  organized  years  ago 
deliberately  charged  off  less  depreciation  in  years  prior  to 
the  advent  of  the  excess  profits  tax  than  should  have  been 
charged  off.  As  a  matter  of  fact,  during  the  years  of 
the  Excise  Tax  they  would  have  been  inclined  to  do  the 
exact  opposite  of  this.  The  average  corporation  that  has 
continued  for  a  number  of  years  has  been  governed  by 
directors  having  good,  common  sense  and  business  acumen. 
Their  desire  was  to  charge  off  sufficient  depreciation  so  that 
they  would  not,  by  declaring  dividends,  liquidate  capital. 
The  judgment  of  such  men  as  to  the  life  of  a  given  machine 
or  other  asset  is  far  better  than  the  judgment  of  any  one 
who  has  not  been  in  a  similar  business  for  the  same  length 
of  time  under  like  conditions.  For  an  auditor  or  an  agent 
arbitrarily  to  state  that  the  depreciation  rate  was  too  low 
in  the  past,  under  most  conditions,  is  absurd.  What  has 
he  to  judge  by  that  is  superior  to  the  basis  of  the  judgment 
cf  those  connected  with  the  management  of  the  concern? 
Nothing  at  all.  Some  seem  to  think  that,  because  it  is 
proper  to  depreciate  a  certain  machine  in  a  certain  factory 
at  the  rate  of  10%,  that  all  similar  machines  in  other  fac- 
tories should  be  given  the  same  rate.  This,  too,  is  absurd. 
I  may  cite  a  case  where  an  auditor  insisted  that  the  depre- 


INVESTED  CAPITAL  ACCOUNTING  231 

ciation  rate  should  be  10%  when,  as  a  matter  of  fact,  the 
machines,  having  been  given  only  ordinary  repairs,  were 
fifteen  years  old  and  still  in  use. 

I  believe  that  A.  R.  M.  106  was  promulgated  solely 
to  overcome  this  attitude — giving  the  average  corporation 
of  years'  standing  credit  with  being  reasonably  honest  and 
having  fairly  good  horse  sense. 

(b)  "Alleged  Failure."    The  word  "alleged"  is  potent 
with  meaning  in  this  sentence.    It  is  clear  that  an  "alleged 
failure"  is  not  necessarily  an  actual  failure  to  charge  off 
sufficient  depreciation  in  the  past. 

(c)  "Actual  Value."     Here,  perhaps,  is  a  term  more 
or  less  ambiguous,  and  if  there  are  any  words  in  A.  R.  M. 
106,  the  use  of  which  was  unfortunate,  it  is  in  the  employ- 
ment of  this  expression.    Still,  any  one  having  a  fair  con- 
ception of  the  fundamental  basis  of  invested  capital,  should 
have  never  raised  the  question  as  to  what  it  means.     It 
could  only  mean,  on  the  basis  of  invested  capital  procedure, 
cost  value  less  depreciation  to  date.    As  a  matter  of  fact, 
there  is  no  such  thing  as  actual  value  based  on  any  other 
hypothesis.    Appreciated  value  may  appear  clear — actual — 
but  it  is  not  actual.    No  appreciation  is  actual  value  until 
that  value  has  been  realized  by  a  sale  or  other  disposition 
of  the  asset. 

(d)  "Might  have  been  taken."    Some  corporations,  in 
real  fat  years,  do  take  depreciation  in  excess  of  what  is 
regarded  as  actual.    They  do  this  in  order  to  be  ultra-con- 
servative and  if  the  corporations  referred  to  in  this  Memo- 
randum had  desired  to  guard  doubly  against  lean  years  of 
the  future  and  had  chosen  to  charge  off  depreciation  in 
excess  of  the  presumptive  depreciation,  there  is  no  question 
in  the  world  but  that  they  could  add  back  that  excess  de- 
preciation to  invested  capital  when    they  had  shown  by 
"affirmative  evidence"  that  such  depreciation  was  excessive. 
Conversely,  and  we  have   (e)   to  consider.     If  insufficient 


232  INVESTED  CAPITAL  ACCOUNTING 

depreciation  had  been  charged  off  and  the  Unit  can  furnish 
"affirmative  evidence"  that  the  depreciation  charged  off 
was  insufficient,  then  we  should  reduce  invested  capital  by 
the  insufficiency  of  depreciation. 

It  is  clear  that  nothing  in  A.  R.  M.  106  prohibits  us 
from  adjusting  surplus,  provided  we  can  furnish  the 
"affirmative  evidence"  that  surplus  is  not  correct,  and  there 
is  nothing  to  prohibit  corporations  from  increasing  its  in- 
vested capital  to  the  extent  that  depreciation  charged  off 
in  prior  years  has  been  excessive,  provided  that  each  fur- 
nishes "affirmative  evidence"  that  such  depreciation  was 
not  a  reasonably  true  amount. 

To  put  it  in  a  nut  shell,  surplus  as  revealed  by  the 
books  of  account  must  be  assumed  to  be  correct  in  so  far 
as  depreciation  or  depletion  is  concerned  unless  the  party, 
be  it  a  taxpayer  or  the  government,  can  show  by  "affirma- 
tive evidence"  that  it  is  not  correct.  No  arbitrary  or  dog- 
matic assertion  that  it  is  not  correct,  by  either  party,  is 
to  be  accepted. 

For  years,  I  have,  in  my  excess  profits  classes  and  in 
my  lectures  in  the  various  Field  Service  and  other  schools 
conducted  by  the  Training  Section,  hammered  the  point 
that  under  no  conditions  can  appreciation  of  values  be  in- 
cluded in  invested  capital  under  the  1918  tax  law.  Others 
have  done  the  same.  It  has  been  shouted  from  the  house- 
tops times  without  number  and  yet,  even  today,  some  one 
will  come  forth  with  a  hypothetical  proposition  in  which 
he  thinks  he  can  show  that  our  teachings  have  been  wrong. 
One  will  try  to  show  that  it  is  justifiable  by  Article  844; 
another  by  A.  R.  M.  106 ;  another  by  certain  computations 
in  the  determination  of  the  reduction  of  invested  capital 
by  reason  of  inadmissible  assets  carried;  another  will 
attempt  to  show  it  in  some  other  form.  All  such  ideas  are 
wrong.  Invested  capital,  under  the  1918  law  is,  and  never 


INVESTED  CAPITAL  ACCOUNTING  233 

can  be  anything  in  addition  to  the  actual  cost  of  the  asset, 
less  depreciation,  depletion  or  obsolescence  to  date. 

There  never  should  have  been  any  question  raised  as 
to  the  basis  of  invested  capital  in  view  of  the  wording  of 
the  law  and  the  regulations  and  the  investigator  or  auditor 
is  unfortunate  if,  knowing  that  he  is  right  in  any  point, 
he  permits  himself  to  be  bluffed  out  of  the  stand  he  takes 
by  any  one  who  is  interested  in  securing  reduction  of  tax 
liability.  When  you  are  right  and  know  you  are  right,  do 
not  allow  any  influence  to  move  you  one  iota. 

Even  though  you  may  have  thought,  in  the  past,  that 
the  invested  capital  concept  is  unconstitutional,  it  was  not 
within  your  province  to  decide  to  that  effect.  It  is  up  to 
the  auditor  and  the  investigator  to  follow  the  law  and  the 
Regulations  as  found  in  the  Unit's  various  publications 
until  the  highest  court  in  the  land  decrees  that  it  is  not 
constitutional.  But  the  Supreme  Court  of  the  United  States 
in  the  La  Belle  Iron  Works  case  has  decided  for  all  time 
that  invested  capital  is  based  on  cost  and  only  upon  cost, 
and  while  you  may  have  doubted  the  statement  of  those 
in  the  Unit  who  have  told  you  this,  times  without  number, 
it  is  sincerely  hoped  that  you  will  accept  the  decision  of 
the  greatest  court  on  earth  as  deciding  the  matter  once 
and  for  all  and  look  upon  it  as  a  question  not  longer  debat- 
able, as,  in  fact,  it  never  was  debatable,  notwithstanding 
that  it  was  debated. 

It  is  surprising  how  often  some  can  be  told  a  fact  and 
still  fail  to  grasp  its  import.  In  Bulletin  No.  30-21-1748 
(page  17)  appeared  an  article  entitled  "A.  R.  M.  106  Ex- 
plained." This  explanation  told  as  plainly  as  words  can 
tell  the  meaning  of  "actual  value."  Either  those  who  receive 
these  bulletins  do  not  read  them  at  all  or  just  scan  through 
them  cursorily  or  they  are  lacking  in  comprehension. 

It  is  thought  best  to  give  the  explanation  in  its  en- 
tirety : 


234  INVESTED  CAPITAL  ACCOUNTING 

A.  R.  M.  106  EXPLAINED 

"Specific  inquiry  has  been  made  as  to  the  meaning  of  the  words 
'actual  value'  as  used  in  Committee  on  Appeals  and  Review  Memo- 
randum 106.  For  the  purposes  of  taxation  depreciation  is  based  upon 
cost.  Accordingly  the  words  'actual  value'  mean  'sound  value,' 
which  is  'original  cost*  (or  value  as  of  March  1,  1913,  if  applicable), 
including  additions  and  betterments  charged  to  capital  account,  less 
depreciation  sustained. 

"Article  161,  Regulations  45  (1920  edition),  defines  the  proper 
allowance  for  depreciation  as  'that  amount  which  should  be  set  aside 
for  the  taxable  year  in  accordance  with  a  consistent  plan  by  which 
the  aggregate  of  such  amounts  for  the  useful  life  of  the  property 
in  the  business  will  suffice,  with  the  salvage  value,  at  the  end  of  such 
useful  life  to  provide  in  place  of  the  property  its  cost,  or  its  value 
as  of  March  1,  1913,  if  acquired  by  the  taxpayer  before  that  date.' 

"It  follows  from  this  definition  that  any  action  on  the  part  of 
a  particular  taxpayer  which  extends  the  useful  life  of  a  depreciable 
asset  beyond  the  normal  or  usual  term,  and  any  circumstance  which 
serves  to  increase  the  salvage  value  of  a  depreciable  asset,  operates 
to  justify  a  reduction  in  the  normal  rate  of  depreciation.  The  depre- 
ciation of  an  asset  is  arrested  where  it  is  maintained  at  a  high  stand- 
ard of  efficiency  either  by  the  exercise  of  unusual  care  in  its  use  or 
by  unusual  maintenance  expenditures. 

"Invested  capital,  as  defined  in  the  excess  profits  tax  law,  is 
a  statutory  concept  and  is  composed  of  two  elements:  (a)  original 
contribution,  and  (b)  earnings  of  the  corporation  available  for  dis- 
tribution but  not  distributed  and  not  dissipated  by  subsequent  operat- 
ing losses.  The  exhaustion  of  this  capital  through  use,  wear  and 
tear  has,  for  the  purpose  of  computing  invested  capital,  the  same 
effect  as  an  operating  loss,  and  unless  this  loss  is  properly  taken 
care  of  out  of  earnings  in  one  way  or  another  earned  surplus  must 
be  adjusted  ion  accordance  with  the  provisions  of  the  regulations. 
There  are  two  ways  of  taking  care  of  this  loss  out  of  income.  One 
is  by  charging  ordinary  repairs  directly  to  expense  and  setting  up 
a  depreciation  reserve  against  which  are  properly  chargeable  all 
renewals  and  replacements;  the  other  is  where  renewals  and  replace- 
ments, as  well  as  repairs,  have  been  charged  directly  against  gross 
income.  Either  way  has  the  effect  of  reducing  the  amount  added 
during  the  year  to  earned  surplus.  Consequently,  the  mere  fact  that 
no  depreciation,  or  a  minimum  depreciation,  has  been  charged  as  such 


INVESTED  CAPITAL  ACCOUNTING  235 

is  not  sufficient  reason  for  reducing  the  earned  surplus  where  renewals 
and  replacements  sufficient  to  care  for  the  decrease  in  value  of 
capital  assets  have  been  charged  directly  to  expense,  or  where  for 
any  of  the  other  reasons  hereinbefore  suggested  less  than  the  normal 
rate  of  depreciation  is  properly  chargeable.  When  a  taxpayer  makes 
this  claim  there  are  two  methods  of  verifying  it.  One  is  by  deter- 
mining the  plant  efficiency  and  the  other  is  by  determining  the 
value  of  the  capital  assets  remaining.  From  an  administrative  stand- 
point the  latter  is  probably  more  practical  even  though  it  may  be 
said  that  the  former  is  more  accurate. 

"Many  cases  have  been  brought  to  the  attention  of  the  Com- 
mittee where  corporations  have  been  in  existence  for  a  long  period 
of  years,  some  of  which  corporations  have  been  in  existence  several 
times  the  ordinary  estimated  life  of  the  depreciable  assets,  and  yet 
those  assets  are  today  in  first-class  condition  and  worth  the  figure 
at  which  they  are  carried  on  the  books,  although  no  depreciation  has 
been  charged  as  such  and  no  additions  to  capital  account  have  been 
made.  In  such  cases  it  is  obvious  that  depreciation  has  been  ade- 
quately cared  for  by  charges  to  expense,  although  it  frequently  hap- 
pens that  it  is  impossible  at  this  late  date  to  segregate  and  specify 
such  charges  and  there  is  no  warrant  in  the  law  or  the  regulations 
for  requiring  the  depreciable  assets  in  such  cases  to  be  written  down 
below  the  figure  at  which  they  are  carried  on  the  books,  since  to 
do  so  is  to  reduce  earned  surplus  twice,  once  through  the  original 
charge  to  expense  (whether  proper  or  improper)  and  again  through 
an  arbitrary  depreciation  charge  required  by  the  Bureau  to  be  set 
up  against  earned  surplus  for  the  purpose  of  computing  invested 
capital. 

"The  controlling  rule  in  this  matter  is  found  in  that  part  of 
article  839  of  Regulations  45,  which  reads: 

"Adjustments  in  respect  of  depreciation  or  depletion 
in  prior  years  will  be  made  or  permitted  only  upon  the 
basis  of  affirmative  evidence  that  as  at  the  beginning  of 
the  taxable  year  the  amount  of  depreciation  or  depletion 
written  oif  in  prior  years  was  insufficient  or  excessive  as 
the  case  may  be. 

"Mere  failure  in  prior  years  to  have  written  off  on  the  books 
the  maximum  or  ordinary  rate  of  depreciation  is  not  in  itself  "affirma- 
tive evidence."  There  is  no  warrant  for  reducing  earned  surplus 


236  INVESTED  CAPITAL  ACCOUNTING 

because  of  alleged  failure  to  charge  off  sufficient  depreciation  in  the 
past,  unless  the  depreciable  assets  of  the  corporation  are  valued  on 
its  books  at  the  beginning  of  the  taxable  year  at  an  amount  in  excess 
of  their  sound  value  at  that  time." 


Apparently  the  explanation  just  quoted  did  not  have 
the  effect  it  should  have  had  and  in  Bulletin  37-21-1822- 
T.  D.  3220  (page  18)  appeared  the  following  over  the  signa- 
ture of  Commissioner  of  Internal  Revenue,  D.  H.  Blair. 

"To  collectors  of  internal  revenue  and  others  concerned: 

"An  examination  of  income  and  excess  profits  tax  returns  for 
1917  and  subsequent  years  has  disclosed  that  many  taxpayers  have 
used  appreciated  and  inflated  values  in  determining  invested  capital 
shown  in  such  returns  contrary  to  section  207  of  the  Revenue  Act 
of  1917  and  section  326  of  the  Revenue  Act  of  1918. 

"This  office  has  held  consistently  that  the  use  of  appreciated  or 
inflated  values  in  determining  invested  capital  is  not  permissible  and 
this  ruling  has  been  sustained  by  the  United  States  Supreme  Court 
in  the  case  of  the  La  Belle  Iron  Works  v.  The  United  States  (41 
Sup.  Ct.,  528;  T.  D.  3051). 

"All  taxpayers  who,  in  the  preparation  of  their  income  and 
excess  profits  tax  returns  for  1917  and  subsequent  years,  have  used 
appreciated  or  inflated  values  in  determining  the  amount  of  their 
invested  capital  are  required  to  file  with  the  collector  of  internal 
revenue  within  90  days  from  date  of  this  decision  amended  returns 
for  each  of  such  years,  in  which  the  invested  capital  shall  be  com- 
puted strictly  in  accordance  with  the  law  and  regulations  and  without 
the  use  of  appreciated  or  inflated  values.  It  is  not  required  that 
such  amended  returns  shall  include  the  figures  shown  in  the  original 
returns  which  are  unaffected  by  this  decision.  Only  such  figures 
as  are  necessary  to  show  the  correct  values  used  in  the  computation 
of  invested  capital  and  such  totals  as  are  necessary  to  a  redeter- 
mination  of  the  tax  need  be  shown.  Payment  of  the  additional  tax 
shown  to  be  due  on  such  amended  returns  must  also  be  made  at  the 
time  the  returns  are  filed. 

"Failure  to  file  amended  returns  within  the  time  specified  will 
subject  taxpayers  to  the  penalties  provided  for  in  section  3176,  United 
States  Revised  Statutes,  as  amended." 


INVESTED  CAPITAL  ACCOUNTING  237 

In  a  still  further  effort  to  make  clear  a  matter  that 
should  have  been  as  clear  as  day  with  the  statements  and 
explanations  already  made  by  the  Bureau,  there  appeared 
in  Bulletin  46-21-1926-O.  D.  1104  (page  12)  an  office  de- 
cision over  the  signature  of  Commissioner  Blair,  as  follows : 


SECTION  326.— INVESTED  CAPITAL 

"Section  326,  Article  839:     Surplus  and  undivided 
profits :    allowance  for  depletion  and  depreciation. 

"Reference  is  made  to  Committee  on  Appeals  and  Review  Memo- 
randum 106  (C.  B.  4,  p.  390)  and  explanatory  memorandum  of  the 
Committee  dated  July  6,  1921  (Bui.  30-31,  p.  17). 

"The  attention  of  the  Commissioner's  office  has  been  called  to 
the  fact  that  article  839  of  Regulations  45  as  interpreted  by  Com- 
mittee Memorandum  106  and  the  memorandum  of  July  6th  has  not 
been  properly  followed. 

"When  the  Regulation  (Art.  839  of  Reg.  45)  was  being  drafted 
it  was  the  intention  of  the  draftsmen  that  a  corporate  surplus  account 
was  not  to  be  disturbed  lightly  and  that  no  change  should  be  made 
in  it  either  by  the  Government  or  by  the  taxpayer  except  upon  ade- 
quate evidence  that  the  surplus  account  was  incorrect.  It  was  the 
view  of  the  draftsmen  that  unless  the  taxpayer  could  show  a  state 
of  error  the  Government  should  deny  a  claim  for  an  increase  in  the 
surplus  shown  by  the  taxpayer's  books;  conversely,  before  a  deduc- 
tion could  be  made  from  the  taxpayer's  surplus  account,  the  Gov- 
ernment must  show  that  such  an  adjustment  is  necessary  to  correct 
the  account.  The  view  was  also  held  that  such  proof  must  be  in  the 
form  of  affirmative  evidence;  that  it  could  not  rest  upon  mere  asser- 
tion or  the  working  out  of  the  theoretical  formula. 

"It  is  my  opinion  that  no  doubt  ever  should  have  existed  as  to 
the  correct  interpretation  of  article  839.  A  taxpayer's  corporate 
surplus  should  not  be  reduced  by  the  arbitrary  adjustment  of  depre- 
ciation and  depletion  for  past  years.  Surplus  accounts  should,  how- 
ever, always  be  carefully  scrutinized  and  checked  up  for  the  purpose 
of  preventing  the  inclusion  therein  of  appreciated  values  of  property. 
In  case  of  doubt  in  such  case  the  burden  should  be  cast  upon  the 
taxpayer  to  prove  that  no  appreciated  values  were  included  in  the 


238  INVESTED  CAPITAL  ACCOUNTING 

surplus.  A  presumption  should  always  exist  that  a  taxpayer's  books 
of  account  reflect  actual  facts.  The  burden  of  proof  is  upon  any 
one  who  attempts  to  impugn  the  correctness  of  the  books  of  account 
— upon  the  Government  if  it  seeks  to  reduce  its  surplus  account  by 
charging  off  depreciation  and  depletion  which  have  not  been  claimed 
by  the  taxpayer  and  upon  the  taxpayer  where  he  claims  that  too 
much  depreciation  and  depletion  have  been  charged  off  in  prior 
years." 

In  view  of  what  has  been  given  in  this  chapter  and 
quotations  which  have  been  made  from  official  publications, 
it  would  appear  to  be  futile  to  add  anything  further.  If 
there  be  any  in  the  Unit  who  are  not  now  able  to  appreciate 
the  full  significance  of  A.  R.  M.  106  (as  well  as  its  limi- 
tations) volumes  written  on  the  subject  would  avail  not. 


CHAPTER  THIRTEEN 
RESUME— A  TYPICAL  CASE 

The  1918  income  tax  return  of  the  Crescent  Manufac- 
turing Company  was  accompanied  by  Balance  Sheets,  copies 
of  which  are  presented  on  pages  240  and  241. 

Also,  the  following  information  was  submitted: 

1.  The  corporation  was  organized  January  2,  1909, 
with  an  authorized  Capital  Stock  of  $300,000,  all  common. 
Of  this  amount  $100,000  was  issued  at  par,  for  cash,  at 
the  time  of  organization.    At  January  2,  1916,  additional 
shares  numbering  1,820  were  issued  at  par  value,  500  of 
which  shares  were  issued  for  tHe  tangible  assets  of  the 
Sherwood  Malleable  Iron  Works,  and  1,000  shares  were 
issued  for  the  Goodwill  of  said  Works.    The  Sherwood  Com- 
pany, shortly    before  this    transaction,  had    been  offered 
$125,000  cash  for  this  Goodwill,  but  since  the  parties  mak- 
ing the  offer  did  not  care  to  take  over  the  tangible  assets, 
the  deal  could  not  be  consummated.    The  par  value  of  all 
shares  is  $100.     (For  obvious  reasons,  all  names  given  in 
this  case  are  fictitious.) 

2.  The  corporation  reported  a  net  taxable  income  for 
1918  equal  to  the  difference  between  the  amount  of  un- 
divided profits  as  at  the  beginning  of  the  year  and  as  at 
the  end  of  the  year,  plus  the  Red  Cross  donation,  plus  the 
Federal  Income  Taxes  paid  in  1918  for  1917,  amounting  to 
$70,000,  or  a  total  income  of  $126,000. 

A  number  of  items  appeared  to  be  questionable,  and 
Agent  Frank  P.  Hadley  was  instructed  to  make  an  exam- 


240  INVESTED  CAPITAL  ACCOUNTING 

ination  of  the  books  of  the  concern  and  to  submit  a  de- 
tailed report. 

The  facts  as  ascertained  by  Hadley,  in  so  far  as  they 
relate  to  this  problem,  are  given  in  the  following  pages, 
beginning  on  page  242. 

Hadley  computed  the  invested  capital  to  be  $529,396.58. 
Do  you  agree  with  him?  If  not,  can  you  locate  the  error? 

He  stated  that  the  net  taxable  income  for  1918 
amounted  to  $158,500.  What  is  your  conclusion? 


ORIGINAL  BALANCE  SHEETS 

Current  Assets :  Dec.  31,1917  Dec.  31, 1918 

Cash $20,000  $38,000 

Accounts  Receivable 40,000  67,000 

Notes  Receivable 18,000     $78,000  33,000  $138,000 

Inventory  Assets: 

Raw  Material 123,000  138,000 

Partly  Finished  Goods...  42,000  60,000 

Finished   Goods 70,000  235,000  76,000     274,000 

Fixed  Assets: 

Machinery 45,000  60,000 

Miscellaneous  Equipment    6,000  8,000 

Furniture  and  Fixtures. .     2,000  2,000 

Buildings 60,000  $60,000 

Less  Depreciation 10,000  50,000 

Switching  Facilities 2,000 

Land 110,000    223,000  75,000     197,000 

Patent  Assets: 

Groups  A.  B.&C 58,000  89,000 

Deferred  Assets: 

Prepaid  Advertising 8,000  7,000 

Prepaid  Salaries 4,000       12,000 

Sinking  Fund  Assets: 60,000  80,000 


INVESTED  CAPITAL  ACCOUNTING 


241 


Securities : 

Railroad  Stocks 100,000 

Railroad  Bonds 10,000 


50,000 
60,000 

5,000 
27,000 

5,000 
15,000 

8,000 


State  of  Ohio  Bonds 20,000 

Liberty  Bonds   (4%) 5,000 

Harmon  Corp.  Bonds 27,000 

City  of  Buffalo  Bonds...     5,000 

Foreign   Corp.   Stock 25,000 

Federal  Res.  Bank  Stock     8,000 
War  Finance  Corp.  Bonds     5,000     205,000  -170,000 

Other  Assets: 

Employees'  Stock    Sub- 
scriptions    18,000  10,000 

Treasury  Stock 27,000  18,000 

Chemical    Formula 6,000 

Goodwill    100,000-    145,000  100,000     134,000 

""$1,016,000  ""$1,089,000 

ORIGINAL  BALANCE  SHEETS 

Current  Liabilities :                                 Dec.  31, 1917              Dec.  31,1918 

Accounts  Payable $65,000  $33,000 

Notes  Payable  (secured) 24,000  22,000 

Notes   Payable    (unsecured)  . .   10,000  15,000 

Interest  on  Mortgage 1,500  $100,500       1,500     $71,500 

Fixed  Liabilities  : 

20-year  Debenture  Bonds 200,000  200,000 

Mortgage  on  Realty 25,000  225,000     25,000     225,000 

Reserves : 

For  Lighting   System 24,000  30,000 

For  Switching  Facilities 19,500  17,500 

For  Development  of  Patents, 

Group    A 35,000  4,000 

For  Bad  Debts 2,000  5,000 

For  Federal  Income  Tax 65,000  85,000 

For  Bond    Redemption 60,000  80,000 

For  Plant    Extension 205,500     35,000     256,500 

Capital,  Surplus,  Etc.  : 

Capital  Stock  Authorized 300,000  300,000 

Surplus 75,000  75,000 

Undivided    Profits 110,000  485,000161,000     536,000 

Total  Liabilities  and  Capital $1,016,000  $1,089,000 


242  INVESTED  CAPITAL  ACCOUNTING 

Note:  All  increases  and  decreases  in  Reserves  are 
reflected  in  Undivided  Profits  Account. 

Part  of  Hartley's  Report 

All  of  the  report  submitted  by  Agent  Hadley  is  not 
given  in  the  following  pages,  but  only  such  portions  as 
Ere  pertinent  to  the  problem  in  hand;  that  is,  the  deter- 
mination of  invested  capital  for  1918,  and  the  amount  of 
taxable  income  for  the  same  period.  The  following  are 
selections  from  the  report: 

1.  No   dividends   were  paid   by   the   corporation   dur- 
ing 1918. 

2.  Donations  were  as  follows :  Red  Cross,  $5,000 ;  Y.  M. 
C.   A.,   $3,000;  Salvation   Army,   $2,000;   total   donations, 
$10,000. 

The  first  of  these  was  charged  to  Expense,  the  second 
to  Undivided  Profits,  and  the  third  to  Undivided  Profits  on 
December  31,  1918,  after  the  closing  of  the  books. 

3.  The  buildings  were  completed  January,  1916,  and 
had  an  estimated  life  period  of  fifty  years. 

4.  Furniture  and  Fixtures  were  purchased  July  1,  1917, 
and  are  subject  to  the  usual  wear  and  tear. 

5.  The  Machinery  should  last  for  fifteen  years,  and 
the  Miscellaneous  Equipment  should  last  for  twenty  years, 
after  purchase.     At  date  of  organization,  $30,000  of  ma- 
chinery was  purchased  and  $3,000  worth  of  Miscellaneous 
Equipment;    January  2,   1916,  machinery    amounting    to 
$15,000  and  Miscellaneous  Equipment  amounting  to  $3,000 
were  purchased.     January  2,  1918,  the  remainder  of  the 
machinery  was  purchased,  and  at  July  1,  1918,  additional 
Miscellaneous   Equipment    was    purchased,   amounting   to 
$2,000. 

6.  Patents,  Group  A  was  purchased  with  stock  issued 


INVESTED  CAPITAL  ACCOUNTING  243 

at  par.  It  is  well  established  that  this  group  would  be 
grabbed  up  by  a  competitor  of  the  corporation  at  an  amount 
greater  than  the  amount  at  which  all  patents  are  carried, 
and  that  it  would  pay  cash  for  the  group.  Twenty-two  thou- 
sand dollars  of  stock  was  issued  for  it. 

Group  B  was  purchased  for  cash,  $20,000. 

Group  C  was  received  by  the  corporation  during  1917, 
in  exchange  for  some  inadmissibles  that  the  corporation 
held  at  that  time. 

In  1917  the  corporation  carried  another  patent  group, 
known  as  Group  D.  December  20,  1917,  this  group  was 
exchanged  for  War  Finance  Corporation  Bonds  in  the 
amount  of  $10,000. 

7.  On  the  books  of  the  corporation  was  found  the  item, 
"Interest  paid  to  carry    inadmissibles,  $1,500."     Of  this 
amount  $500  was  for  money  borrowed  to  carry  Buffalo 
City  Bonds  and  the  Harmon  Corporation  Bonds,  half-and- 
half.    The  balance,  or  $1,000,  was  for  money  borrowed  to 
carry  railroad  stocks.    The  Agent  recommended  that  this 
item  be  disallowed  as  expense,  and  that  net  income  be  in- 
creased by  $1,500.    See  Article  121. 

(If  you  should  determine  that  a  part,  or  all,  of  this 
interest  should  be  disallowed  as  a  deduction,  and  if  your 
conclusion  be  correct,  a  certain  amount  of  inadmissibles 
should  be  deemed  admissible  to  be  in  conformity  with  Arti- 
cle 817,  (b).  For  the  present  we  shall  ignore  this  phase 
of  the  question.  There  seems  to  be  difference  of  opinion 
as  to  how  it  should  be  solved.  Further,  we  should  not  have 
known  that  the  corporation  borrowed  this  money  for  this 
particular  purpose  except  for  the  fact  that  the  Treasurer 
happened  to  be  the  man  that  Diogenes  missed.) 

8.  Of  the  railroad  stocks,  $50,000  were  sold  July  15, 
1918,  for  $55,000,  which  amount  included  accrued  but  un- 
paid dividends  amounting  to  $3,000.     Of  the  proceeds  of 


244  INVESTED  CAPITAL  ACCOUNTING 

the  sale,  $50,000  were  at  once  reinvested  in  railroad  bonds. 
The  $5,000  was  included  in  income. 

9.  The  foreign  corporation  stock  items  were  as  follows : 

Liverpool  Cotton  Mills,  $10,000.  This  corporation 
receives  no  income  from  sources  within  the  United 
States. 

Bristol  Valve  and  Gear  Company,  $15,000.  This 
concern  has  a  Branch  in  the  United  States  and  its  goods 
are  handled  quite  generally  by  jobbers  in  mill  supplies 
throughout  the  United  States.  During  1917  and  1918, 
owing  to  the  war,  this  company  did  business  at  a  loss, 
hence  no  dividends  were  declared  for  those  years. 

The  $10,000  block  of  Cotton  Mills  stock  was  sold 
July  2,  1918,  at  a  profit  of  $1,000.  Dividends  received 
on  this  stock,  $800.  These  amounts,  total  $1,800,  were 
included  in  the  taxpayer's  report  of  income. 

10.  The  state  of  Ohio  bonds  were  sold  at  cost,  Sep- 
tember 10,  1918. 

11.  It  was  found  that  Robert  Green,  one  of  the  stock- 
holders and  a  director  of  the  corporation,  purchased  stock 
January  2,  1916,  to  the  amount  of  $32,000.    To  make  the 
purchase  he  borrowed  $22,500  at  6%  interest.    The  inter- 
est has  been  paid  promptly,  but  none  of  the  original  bor- 
rowings has  been  paid,  except  one  amount  of  $5,000.    To 
procure  this  money  Green  found  it  necessary  to  borrow 
it  from  the  corporation,  and  gave  his  interest-bearing  note 
at  two  years  from  September  10,  1917,  without  security. 
Bradstreet  does  not  give  Green  a  rating,  and  states  "Slow 
pay." 

12.  The  agent  states  that  he  made  a  careful  examina- 
tion of  all  entries  and  that  the  only  items  to  which  he  can 
take  exception  are:   sufficient  depreciation  was  not  charged 


INVESTED  CAPITAL  ACCOUNTING  245 

off  and  he  recommends  that  Prepaid  Advertising  and  Sal- 
aries Advanced  be  charged  to  Expense.  '  Also,  he  found  that 
Salaries  Advanced  Account  had  a  debit  balance  of  $1,000 
at  the  end  of  the  year. 

13.  No  interest  was  received  on  the  Railroad  Bonds 
and  the  corporation  claimed  that  failure  to  receive  any  such 
interest  from  these  holdings  justified  it  in  including  the 
bonds  as  admissible  assets.     (See  Article  815.)     In  your 
solution,  be  careful  to  state  specifically  what  conclusion  you 
arrive  at  with  reference  to  the  legality  of  this  matter  and 
give  specific  reasons  for  your  conclusion. 

14.  The  $30,000,  par  value,  Treasury  Stock  held  at 
December  31,  1917,  was  purchased  at  $90  a  share,  July  2, 
1917.    August  2,  1918,  $10,000  par  value,  of  this  stock  was 
sold  at  $110  a  share.    The  difference  between  the  price  the 
corporation  paid  for  the  stock  and  the  selling  price  was 
included  in  Undivided  Profits  as  at  December  31,  1918. 

(In  this  connection,  you  should  note  that  the  stock  was 
originally  sold  at  par  value.  It  was  re-acquired  at  near 
par  value,  and  can  in  no  sense  be  construed  as  having  been 
acquired  as  a  gift  or  "at  a  price  substantially  less  than 
par,"  hence  the  so-called  "double  deduction"  does  not  enter 
in.  Note,  also,  that  the  corporation  carried  the  stock  at 
cost;  in  other  words,  the  book  value  differs  from  par 
value.) 

15.  The  remainder  of  the  unissued  stock,  180  shares, 
was  sold  to  employees  December  30,  1917,  under  a  contract 
by  which  a  percentage  of  the  salaries  was  to  be  taken  out 
each  month  in  payment  for  the  stock,  which  actually  was 
issued  to  the  employees.    The  amount  payable  each  month 
was  $800. 

The  matter  of  withholding  these  amounts  on  pay  days 
was  overlooked  until  November  2,  1918,  at  which  time  it  was 
found  that  $8,000  was  due.  The  employees  at  that  date 


246  INVESTED  CAPITAL  ACCOUNTING 

paid  $5,000  of  the  amount  due  in  cash,  and  the  balance, 
$3,000  was  paid  in  notes,  drawing  interest,  in  face  of  the 
fact  that  the  laws  of  the  state  under  which  the  charter  was 
granted  forbid  the  acceptance  of  notes  for  stock.  There  is 
not  the  least  question  but  that  the  notes  are  collectible  and 
are  worth  face  value  at  the  bank.  The  November  and  De- 
cember payments  were  made  January  5, 1918  (prior  to  filing 
return  for  1918). 

16.  The  land  consisted  of  four  adjoining  and  similar 
lots.    During  the  year  two  lots  were  sold  for  $75,000  cash. 
The  value  of  the  four  lots  as  at  March  1, 1913,  was  $150,000, 
but  no  change  was  made  in  the  book  values,  which  always 
had  been  the  same  as  cost — $110,000.    After  the  sale,  how- 
ever, the  company  could  not  see  any  reason  why  its  books 
should  not  reflect  actual  worth  and  the  book  value  of  the 
remaining  two  lots  was  raised  to  sale  value — $75,000.    Since 
invested  capital  is  almost  wholly  based  on  the  balance  sheet 
as  at  the  beginning  of  the  year,  it  was  felt  that  this  action 
would  make  no  difference  in  the  amount  of  taxes  due  the 
government  for  1918. 

17.  The  formula  was  acquired  September  13, 1918,  being 
paid  for  with  War  Finance  Corporation  Bonds  in  the  amount 
of  $5,000. 

18.  During  the  year  the  work  of  surveying  for  the  rail- 
road switches  was  done,  and  some  other  work  was  done  at 
grading,  amounting,  all  told,  to  $2,000. 

Of  the  amount  in  reserve  for  the  development  of  pat- 
ents, $31,000  was  expended  on  group  A. 

For  several  years  the  corporation  has  been  building  up 
a  Reserve  for  Lighting  Plant.  At  the  end  of  the  taxable 
year  $6,000  was  added  to  this  account,  and  charged  to  Sur- 
plus. (This  account  is  purely  Allocated  Surplus.) 

19.  Receivables  to  the  amount  of  $3,175.40  were  found 
to  be  uncollectible  and  charged  to  P.  and  L. 


INVESTED  CAPITAL  ACCOUNTING  247 

20.  For  reasons  of  its  own  the  corporation  makes  a 
practice  of  holding  Surplus  Account  at  a  given  figure,  always 
showing,^  on  the  balance  sheet,  under  Undivided  Profits,  the 
fluctuations  in  net  worth. 

21.  In  the  Agent's  report  he  frankly  admitted  that  he 
was  at  a  loss  to  know  what  to  do  with  the  Debenture  Bonds, 
and,  as  is  sometimes  done,  he  left  it  up  to  the  Unit  to  make 
a  decision.    He  computed  two  invested  capital  amounts,  and 
taxes  based  on  the  two  figures,  one  amount  of  invested  cap- 
ital named  by  him  was  about  $200,000  less  than  the  other. 
The  amount  named  on  page  240  does  not  include  Deben- 
ture Bonds. 

The  bonds  were  issued  at  3%,  January  2,  1916,  and 
only  to  stockholders,  and  paid  for  in  cash  at  face  value.  It 
is  stipulated  that  the  interest  shall  be  paid  semi-annually, 
but  no  interest  has  ever  been  paid.  Each  year  Accounts 
Payable  is  credited  with  $6,000  and  Interest  Expense  is 
debited  a  like  amount.  Another  thing  to  consider  in  this 
connection  is  that  on  December  31,  1918,  by  resolution  of 
the  board  of  directors,  it  was  decided  to  make  application 
early  in  January,  1919,  for  the  privilege  of  increasing  Cap- 
ital stock  to  $500,000,  the  several  stockholders  to  surrender 
all  bonds  for  an  equal  amount  of  the  new  issue  of  stock, 
for,  as  they  view  the  matter,  the  bonds  are  capital  stock  in 
all  respects  except  in  name.  Of  course,  when  this  is  done, 
Bond  Redemption  Reserve  Account  will  be  charged  with 
$80,000  and  Surplus  will  be  credited  with  a  like  amount. 
Capital  Stock  account  will  be  credited  with  $200,000  and 
the  Debenture  Bond  liability  account  will  be  charged  with 
$200,000. 


STOP  RIGHT  HERE— NOW. 

Would  you  deliberately  cheat  yourself  ? 

If  you  are  willing  to  treat  yourself  fairly  show  it  now 


248  INVESTED  CAPITAL  ACCOUNTING 

by  abstaining  from  looking  at  any  of  the  pages  that  follow 
this  page  until  you  have  worked  the  problem  just  presented, 
and  have  found  answers  to  these  three  questions : 

1.  What  is  the  invested  capital  of  this  corporation? 

2.  What  is  the  taxable  income  of  this  corporation? 

3.  On  the  basis  of  the  amended  balance  sheets  as  at 
December  31,  1918,  how  much  goodwill  would  you 
allow  this  corporation  for  the  year  1919  ? 

The  pages  that  follow  this  page  contain  a  complete 
solution  to  the  problem,  but  if  you  have  studied  carefully 
the  five  preceding  chapters,  you  will  not  need  the  solution 
to  aid  you.  Not  a  question  can  come  up  in  this  problem  that 
has  not  been  covered  in  those  chapters — somewhere. 

Solve  the  problem  by  your  own  efforts  and  the  aid  of 
the  preceding  Chapters.  Then  compare  your  solution  with 
the  one  given  in  the  following  pages.  DO  NOT  solve  one 
thing  at  a  time  and  then  refer  to  the  official  solution  to  see 
if  you  are  right  as  far  as  you  have  gone.  CLIP  THE  FOL- 
LOWING PAGES  TOGETHER,  and  do  not  withdraw  the 
clip  until,  such  time  as  you  have  determined  upon  the  answers 
to  the  three  questions  given  above.  BE  HONEST  WITH 
YOURSELF. 


CHAPTER  FOURTEEN 
SOLUTION  TO  CHAPTER  THIRTEEN 

In  terming  this  problem  a  typical  case,  it  is  not  intended 
to  convey  the  impression  that  all  things  have  been  fully 
explained  in  the  agent's  report  down  to  minute  details,  or 
even  in  some  things  of  greater  moment.  Had  such  a  course 
been  followed  it  certainly  would  have  little  attraction  for 
the  worker  who  desires  to  "dig  things  out."  The  only  per- 
sons worth  while  are  those  who  try  to  do  just  that— dig 
things  out.  For  others  no  problem  could  be  sufficiently  set 
forth  to  meet  their  desires — perhaps  their  needs.  The  am- 
bitious man  wishes  to  discover  for  himself,  so  far  as  possible. 
The  indolent  and  all-wise  inefficient  want  to  be  told,  and  we 
have  not  sufficient  time  for  that. 

Had  all  things  been  made  perfectly  clear  in  the  problem 
it  would  have  ceased  to  be  a  problem  and  would  have  become 
merely  a  monograph  of  instruction  that  would  have  defeated 
its  very  purpose — the  bringing  out  what  you  have  learned 
from  the  previous  chapters  of  the  series,  each  of  which  may 
properly  be  called  a  monograph  on,  or  an  epitome  of  one 
phase  of  invested  capital. 

Further,  had  all  things  been  made  clear,  it  could  not 
be  called  a  typical  case,  for  no  typical  case  has  ever  been 
audited  that  did  not  leave  some  things  to  judgment,  reason, 
discrimination,  or  penetrativeness.  The  auditor  without 
such  qualifications  is  at  the  wrong  job — a  round  peg  in  a 
square  hole. 

To  illustrate:  A  glance  at  the  Balance  Sheet  as  pre- 
sented reveals  the  fact  that  the  corporation  is  carrying 


250  INVESTED  CAPITAL  ACCOUNTING 

more  goodwill  (which,  of  course,  may  include  patents)  than 
is  justifiable  by  the  statements  made.  It  is  stated  that 
$100,000  stock  was  issued  for  the  Goodwill  of  the  Sher- 
wood Works,  and  later  it  is  shown  that  Stock  was  issued 
for  a  patent.  The  auditor  with  a  penetrating  mind  and  a 
fair  acquaintance  with  the  law  (state  laws)  as  applied  to 
corporations  would  discover  that  a  patent  or  patents  must 
have  been  embraced  in  the  $100,000  Goodwill,  for  the  total 
stock  issue  could  not  possibly  exceed  $300,000,  and  the  issue 
of  the  entire  3,000  shares  was  fully  accounted  for.  It  should 
be  quite  patent  that  a  concern  as  large  as  this  would  not 
deliberately  issue  more  stock  than  was  authorized  by  its 
charter. 

Likewise,  the  adjustments  to  Treasury  Stock  values, 
prepaid  salaries,  real  estate  values  and  profits,  formula 
value,  and  other  things  might  have  been  more  fully  ex- 
plained, only  to  "kill"  the  intent  of  the  problem.  This 
problem  was  constructed  for  the  benefit  of  those  who  think 
and  think  deeply.  The  superficial  are  wasting  their  time  in 
considering  it  at  all. 

There  are  two  good  methods  of  computing  invested 
capital.  The  way  that  it  is  presumed  to  be  done  by  the 
taxpayer  is  for  him  to  fill  out  the  various  schedules  in  form 
1120,  making  the  necessary  adjustments  in  Schedule  E 
to  L,  inclusive,  and  to  summarize  the  whole  under  sched- 
ule II. 

This  is  the  method  that  is  followed  by  a  good  many 
auditors,  but  since  they  do  not  have  an  unlimited  supply 
of  blanks  of  form  1120  it  is  necessary  to  resort  to  the 
making  of  dummy  forms,  which  entails  unnecessary  work. 

If  the  balance  sheets  submitted  by  the  taxpayer  evi- 
dence "substantial  changes  during  the  taxable  year"  in 
the  amount  of  inadmissibles  carried,  an  adjusted  balance 
sheet  must  be  set  up.  In  this  connection  it  is  fitting  to 


INVESTED  CAPITAL  ACCOUNTING  251 

remark  that  all  changes  in  the  inadmissible^  in  the  problem 
in  hand,  are,  for  illustrative  purposes,  regarded  as  "sub- 
stantial." 

The  second  method  is  to  set  up  new  balance  sheets, 
entering  each  item  at  its  invested^capital  value.  The  in- 
vested capital  will  then  be  the  stock  outstanding,  plus  sur- 
plus allocations,  and  the  pro-rated  amount  of  stock  sold 
during  the  year,  LESS  any  reduction  that  may  have  taken 
place  by  reason  of  income  tax  paid,  dividend  distribution, 
treasury  stock  bought,  or  stock  retired — all  pro-rated  over 
the  period. 

The  second  method  deals  only  with  the  balance  sheet 
and  is  complete  within  itself;  entirely  free  from  schedules. 
The  first-named  method,  in  the  event  of  substantial  changes 
in  inadmissibles,  requires  the  setting  up  of  the  amended 
balance  sheets  in  addition  to  working  out  the  several 
schedules. 

It  is  the  opinion  of  the  writer  that  the  second  method 
is  much  the  simpler,  less  liable  to  error,  and  from  the  view- 
point of  accounting  technique,  more  logical. 

But,  since  opinions  differ,  and  the  fact  that  some  will 
prefer  the  first;  and  others  the  second  method,  both  will 
be  presented  in  this  solution. 

In  the  solution  following,  only  such  schedules  will  be 
shown  as  enter  into  this  problem,  and  the  line  numbers 
will  conform  to  form  1120  (1918),  without  giving  the  ex- 
planatory matter  given  opposite  each  line  in  the  form.  It 
may  be  good  practice  to  fill  out  a  blank  form  from  the 
figures  here  given.  There  seem  to  be  several  variants  of 
this  form,  especially  as  regards  schedule  E,  and  for  that 
reason  the  copy  you  may  fill  out  may  not  harmonize  exactly 
with  the  line  numbers  we  shall  here  use. 


252  INVESTED  CAPITAL  ACCOUNTING 

Schedule  E 
Line  3 . .  $282,000 


Line  4 $282,000 

Line  6 . .  390,500 


Line  8 $672,500 

Line  9 27,000 


Line  10. . $645,500 


(The  writer  has  seen  three  variations  of  line  9.     In 
one,  it  was  numbered  10,  in  one  it  did  not  appear  at  all.) 

Schedule  G 

Line  1 $59,000 

Line  6 24,150 


Line  9. .  $83,150 


Schedule  H 

Line  1.  Treasury  Stock Aug.  2/18  10  $110.  $11,000  152  $4,580.82 

Line  2.  Stock  issued  to 

employees Nov.  2/18  50     100.       5,000     60       821.92 


$5,402.74 

(Red  ink  entry) 

1917  income  tax  paid $70,000  200  38,356.16 

Less  stock  additions  as  lines  1  and  2 5,402.74 


Net  reduction $32,953.42 


Schedule  II — Invested  Capital 
Line  1 $645,500.00 


Line  3 $645,500.00 

Line  4..  83,150.00 


Line  5 $562,350.00 

Line  6.. 32,953.42 


Line  7 $529,396.58 


INVESTED  CAPITAL  ACCOUNTING 


253 


Line  7  would  indicate  the  invested  capital  had  there 
been  no  inadmissibles  carried.  To  arrive  at  the  amount 
of  deduction  made  necessary  on  account  of  inadmissibles, 
we  must  set  up  a  new  balance  sheet,  adjusted  in  accordance 
with  income-tax  procedure.  From  now  on  we  shall  present 
the  second  method  of  arriving  at  invested  capital,  begin- 
ning with  the  amended  balance  sheets  on  the  next  page. 
Regardless  of  the  method  employed  in  arriving  at  invested 
capital,  it  is  necessary  to  ascertain  the  average  of  the 
balance  sheets  as  at  the  beginning  and  as  at  the  end  of 
the  taxable  period.  The  sale  of  inadmissibles  during  the 
period1  is  likely  to  make  this  a  tedious  process. 

AMENDED  BALANCE  SHEETS 

ASSETS 


Current  Assets :  Dec.  31,1917 

Cash $20,000 

Accounts  Receivable . .  40,000 

Notes  Receivable 18,000     $78,000 


Dec.  31, 1918 
$38,000 
67,000 
30,000     $135,000 


Inventories : 

Raw  Material 123,000 

Partly  Finished  Goods  42,000 
Finished  Goods 70,000    235,000 


138,000 
60,000 
76,000  274,000 


Fixed  Assets: 

Machinery    . .  .$45,000 
Less    Depre- 
ciation . . .  20,000  25,000 


$60,000 
24,000      36,000 


Miscellaneous 

Equipment   .     6,000 
Less    Depre- 
ciation . . .     1,650     4,350 

Furniture   and 

Fixtures   . . .     2,000 
Less    Depre- 
ciation ...        100     1,900 


8,000 
2,000 

2,000 
300 


6,000 


1700 


254 


INVESTED  CAPITAL  ACCOUNTING 

60,000 
3,600       56,400 


Buildings    60,000 

Less   Depre- 
ciation    . .     2,400  57,600 


Railroad 

Facilities  2,000 

Land 110,000    198,850  55,000      157,100 

Deferred  Assets : 

Prepaid  Advertising        8,000  7,000 

Salaries  Advanced...     4,000       12,000  1,000          8,000 

Patent  Assets: 

Group  A 22,000  53,000 

Group  B 20,000  20,000 

Group    C 16,000      58,000  16,000        89,000 

Sinking  Fund  Assets : "~  60,000  80,000 

Securities : 

Railroad   Stocks 100,000  50,000 

Railroad    Bonds 10,000  60,000 

State  of  Ohio  Bonds..  20,000 

Liberty  Bonds  (4% ) . .     5,000  5,000 

Harmon  Corporation 

Bonds  27,000  27,000 

City  of  Buffalo  Bonds.     5,000  5,000 

Foreign  Cor.  Stock 

(inadmissible)  ....  15,000  15,000 

Foreign  Cor.  Stock 

(admissible)  10,000 

Federal  Reserve  Bank 

Stock 8,000  8,000 

War  Finance  Corpora- 
tion Bonds 5,000  205,000  170,000 

Other  Assets: 

Chemical  Formula 5,000 

Goodwill    $63,000  63,000 

Less  Pat- 
ents   A 22,000  41,00022,000        41,000      46,000 

$887,850  "  $959,100 


INVESTED  CAPITAL  ACCOUNTING 


255 


LIABILITIES 

Current  Liabilities :                                 Dec.  31,1917  Dec.  31,1918 

Accounts    Payable $65,000  $33,000 

Notes    Payable 34,000  37,000 

Interest  on  Mortgage 1,500  $100,500       1,500     $71,500 

Fixed  Liabilities: 

20-year  Debenture  Bonds 200,000  200,000 

Mortgage  on  Realty 25,000  225,000     25,000     225,000 

Reserves : 

For  Lighting   System 24,000  30,000 

For  Railroad    Facilities 19,500  17,500 

For  Development   of   Patents, 

Group  A 35,000  4,000 

For  Bad   Debts 2,000  5,000 

For  Federal  Income  Tax 65,000  85,000 

For  Bond  Redemption 60,000  80,000 

For  Plant  Extension 205,500     35,000     256,500 


Capital  and  Surplus: 

Capital  Stock  Outstanding. .  .252,000 
Surplus  and  Undivided  Profits.  104,850 


267,000 
356,850  139,100 

$887,850 


406,100 
$959,100 


Arriving  at  Invested  Capital 

Stock  outstanding  at  beginning  of  the  year $252,000.00 

Surplus  and  Undivided  Profits 104,850.00 

Surplus  Allocations  (true  Reserves) 205,500.00 


Invested  Capital  Basis $562,350.00 

Plus :   Treasury  Stock  sold  August  2,  1918 — 

152/365x$ll,000=    $4,580.82 

Employees'  Stock  paid  No.  2 — 

60/365x$5,000=    821.92  5,402.74 


Legs:  Income  tax  paid  June  15,  1918 — 
200/365x$70,000=:    


$567,752.74 
38,356.16 


$529,396.58 


256  INVESTED  CAPITAL  ACCOUNTING 

The  amount  given  at  the  bottom  of  the  previous  page 
is  the  same  as  the  amount  stated  in  Line  7,  Schedule  II. 
This  must  be  reduced  by  a  certain  percentage,  which  per- 
centage is  arrived  at  by  dividing  the  averaged  amount  of 
inadmissibles  held  throughout  the  year  by  the  total  admis- 
sible assets  and  inadmissible  assets,  averaged  throughout 
the  year. 

See  Paragraph  8,  page  243  (Railroad  Stocks — Bonds). 


Profit  on  sale $2,000 

Other  income 3,000  Profit  is  to  total  income 

as  2  is  to  5,  or  2/5 
Total  income $5,000 

2/5  of  $100,000  is  $40,000,  the  amount  that  becomes  admissible  up  to 
date  of  the  sale — 195  days. 

195/365x$40,000=   (admissible) $21,369.86 

Receipts;  $55,000,  admissible  for  remainder  of  year — 170 
days. 

170/365x$55,000  =   (admissible) 25,616.44 


Total  admissible $46,986.30 

Total,  $100,000,  less  restoration,  40,000,  leaves  $60,000  in- 
admissible. Of  this  amount  $50,000  remained  constant 
throughout  the  year,  and  $10,000  was  inadmissible  up 
to  the  date  of  the  sale — 195  days — 

195/365x$10,000  =    (inadmissible) 5,342.46+ 

Constant  inadmissibles 50,000.00 


Total  average  of  this  asset  (including  bonds  bought) $102,328.76+ 


Proof  of  Computation 

It  will  be  noted  that  $5,000  came  in  on  July  15  and 
that  this  amount  was  included  in  the  averaging  process, 
hence,  if  we  pro-rate  the  $5,000  for  the  period  it  was  in 


INVESTED  CAPITAL  ACCOUNTING  257 

the  business  and  deduct  the  pro-rated  average  from  the 
total  given  above,  we  should  arrive  at  the  original  holdings 
—$100,000. 

170/365x$5,000^=$2,328.767 

Deducting  $2,328.767  from  $102,328.76+  leaves  |the 
original  amount  of  stock  held — $100,000.  Had  this  stock 
been  sold  at  a  profit,  with  no  other  income  from  this  source, 
the  entire  $100,000  would  become  admissible  for  the  year. 
See  Paragraph  10  (State  of  Ohio  Bonds) . 

This  inadmissible  was  carried  by  the  corporation  for 
a  period  of  252  days — 

252/365x$20,000=  (average  inadmissible)  $13,808.22 

The  proceeds  of  the  sale  were  not  reinvested 
in  inadmissibles,  hence  they  are  admissible  for  the 
remainder  of  the  period — 

113/365x$20,000=  (average  admissible)  —     6,191.78 


Total  holdings $20,000.00 

See  Paragraph  17  (Formula) . 

Inasmuch  as  the  Formula  was  paid  for  with  the  equiva- 
lent of  cash,  it  must  be  allowed  reflection  in  Surplus  at 
the  amount  paid  for  it.  The  fact  that  it  was  purchased 
with  an  inadmissible,  does  not  require  that  it  be  classed  as 
an  inadmissible. 

The  proceeds  of  the  sale  (it  is  the  equivalent  of  a 
sale)  become  admissible  for  the  remainder  of  the  period, 
or  110  days — 

110/365x$5,000=  (average  admissible) $1,506.85 

The  asset  was  inadmissible  for  a  period  of  255  days — 
255/365x$5,000=  (average  inadmissible)— $3,493.15 

Averaging  the  Balance  Sheet  (see  page  191,  Chapter  Ten). 


268  INVESTED  CAPITAL  ACCOUNTING 

Item  Admissible  Inadmissible 

Railroad  Stocks— restored . $21,369.86 

Total  receipts 25,616.44 

Average  of  unrestored $5,342.46 

Constant  portion 50,000.00 

State  of  Ohio  Bonds 6,191.78        13,808.22 

War  Finance  Corporation  Bonds 1,506.85          3,493.15 


Totals  of  averaged  amounts $54,684.93       $72,643.83 

To  the  above  averaged  inadmissible  amount 
must  be  added  the  inadmissibles  that  were 
constant  during  the  period — 

City  of  Buffalo  Bonds $5,000.00 

Foreign  Corporation  Stock 15,000.00 

Federal  Reserve  Bank  Stock 8,000.00        28,000.00 

Total  averaged  inadmissibles  for  the  year $100,643.83 

Footings  of  Adjusted  Balance  Sheets  as  given     12-31-17       12-31-18 
on  page   254 $887,850.00  $959,100.00 

Less  the   totals   of  the  averaged   items  given 

above;  that  is,  $54,684.93  plus  $100,643.83. . .   155,328.76     155,328.76 

$737,521.24  $803,771.24 

Added  and  Averaged 803,771.24 

2)  $1,536,292.48 


$768,146.24 

This  is  the  average  of  all  assets  not  previously  consid- 
ered. To  get  the  true  average  of  all  assets  held  throughout 
the  period  there  must  be  added  to  this  amount  the  amount 
of  deduction  above — 

The  above  averaged  amount $768,146.24 

The  averaged  admissibles 54,684.93 

The  average  inadmissibles 100,643.83 


Average  of  the  total  assets $923,475.00 

Proof 

Balance  Sheet  at  beginning  of  year $887,850.00 

Balance  Sheet  at  the  end  of  year 959,100.00 


2)  $1,846,950.00 
General   Average $923,475.00 


INVESTED  CAPITAL  ACCOUNTING  269 

The  net  amount  of  invested  capital  may  be  obtained 
by  the  use  of  the  following  formula : 

($100,643.83  \ 
x$529,396.58    )=$471,700.92 
923,475.00  / 


Schedule  II  form  1120  may  now  be  completed: 

Line  7   (brought  forward  from  page  255) . .  .$529,396.5B 
Line  8  .  , .   57,695.66 


Line  9   (net  invested  capital) $471,700.92 

Comment  on  the  Agent's  Report:    (The  paragraph  numbers 
refer  to  the  paragraphs  in  the  problem). 

While  it  may  be  unusual  for  a  corporation  to  hold 
Federal  Reserve  Bank  Stock,  still  it  is  a  legal  possibility 
with  certain  limitations  and  the  apparent  stipulation  that 
the  holdings  of  an  individual  or  corporation  may  not  exceed 
$25,000.  Hence,  to  the  well-informed,  this  item  will  not  be 
questionable. 

2.  The  charge  to  Undivided  Profits,  after  the  closing 
of  the  books  for  the  period  would  not  affect  1918  income, 
so  far  as  tax  is  concerned.  It  would  reduce  invested  capital 
for  the  next  period. 

The  other  donation  charged  to  Undivided  Profits  does 
affect  the  taxable  income.  Had  the  charge  not  been  made, 
the  Undivided  Profits  account  would  be  larger  by  the 
amount  of  the  donation,  and  since  we  are  to  arrive  at  the 
net  income  for  the  period  from  a  study  of  the  balance  sheet, 
we  must  include  this  $3,000  donation. 

6.  It  matters  not  what  a  patent  may  be  worth,  or 
what  some  one  is  willing  to  pay  for  it.  What  it  cost  the 


260  INVESTED  CAPITAL  ACCOUNTING 

corporation  is  the  only  factor  to  be  considered  in  computing 
invested  capital. 

Group  B,  being  purchased  for  cash,  does  not  come 
within  the  25%  limitation.  It  is  still  a  form  of  goodwill, 
but  it  is  allowable  to  the  full  amount  of  cash  paid  for  it. 

Group  C  was  paid  for  in  inadmissibles.  It  is  to  be 
presumed,  of  course,  that  the  inadmissibles  were  worth 
$16,000,  hence  they  are  the  equivalent  of  cash.  An  asset 
acquired  in  exchange  for  an  inadmissible  is  not  treated  as 
inadmissible  unless  it  is,  ipso  facto,  inadmissible. 

7.  Interest  appears  to  have  been  paid  as  follows : 

Buffalo  City  Bonds $250 

Harmon  Corporation  Bonds 250 

Railroad  Stock 1,000 

The  only  unallowable  item  of  interest  is  the  interest 
paid  on  the  Buffalo  (municipal,)  City  Bonds.  Interest 
received  on  the  Harmon  Corporation  Bonds  is  taxable, 
therefore,  interest  paid  to  carry  such  bonds  is  an  allowable 
deduction.  All  income  from  industrial  bonds  is  taxable. 

Note  that  Article  121  states :  "But  interest  on  indebted- 
ness incurred  or  continued  to  purchase  or  carry  securities, 
such  as  municipal  bonds,  the  INTEREST  upon  which 
*  *  *  ."  Dividends  received  are  not  mentioned — only 
interest,  therefore,  interest  paid  on  money  used  to  carry 
or  purchase  stocks  is  deductible.  But,  notwithstanding  all 
that,  stocks  are  inadmissible.  See  Article  815. 

8.  Railroad  stocks  are  inadmissible.    Railroad  bonds, 
being  industrials,  are  admissible. 

9.  Stock  held  by  a  domestic  corporation  in  a  foreign 
corporation  deriving  no  income  from  sources  within  the 
United  States  is  admissible.     If  income  be  derived  from 
sources  within  the  United  States,  the  stock  is  inadmissible. 


INVESTED  CAPITAL  ACCOUNTING  261 

11.  It  matters  not  how  Robert  Green  procured  the 
money  with  which  to  purchase  the  stock.    The  corporation 
received  payment  for  the  stock  issued  to  him  and  that  is 
all  that  concerns  us.    That,  later,  he  borrowed  some  money 
from  the  corporation  with  which  to  pay  one  of  his  debts, 
while  it  may  be  unusual,  it  has  no  effect  on  invested  cap- 
ital.   Not,  at  any  rate,  until  such  time  as  the  account  may 
be  found  to  be  worthless  and  is  charged  off  the  books  along 
with  other  Bad  Debts. 

12.  Liberty  Bonds  are  admissible  assets. 

13.  One  can  scarcely  blame  the  corporation  if  it  formed 
the  opinion  that  its  Railroad  Bond's  would  have  been  inad- 
missible if  income  on  them  had  been  received.    In  one  of 
the  audit  sections  it  was  the  practice  for  months  to  classify 
industrials  as  inadmissibles  and  the  change  to  the  correct 
procedure  was  made  at  the  instance  of  the  writer  of  this 
book.     Article  815  might  have  been  stated  a  little  more 
clearly. 

14.  The  profit  made  on  the  sale  of  Treasury  Stock  is 
not  taxable.    See  Articles  542  and  862. 

15.  Inasmuch   as   the  jurisdiction   under  which  the 
charter  of  this  corporation  was  granted  did  not  confer  the 
right  to  take  notes  in  payment  of  stock,  it  certainly  had 
no  right  to  sell  stock  on  open  account.     But  whether  or 
not  it  might  have  stretched   its  privileges,  it  makes  no 
difference  here  for  unpaid-for  stock  may  not  be  included  in 
invested  capital.    We  should  not  include  in  invested  capital 
the  $3,000  paid  for  in  notes,  for  the  corporation  had  no 
legal  right  to  accept  the  notes.    A  corporation  may  not  be 
given  the  benefit  of  invested  capital  which  is  the  result  of 
an  illegal  act  on  its  part. 

16.  For  invested  capital  purposes  the  cost  of  the  land 
is  the  only  element  to  be  considered.     Inasmuch  as  the 


262  INVESTED  CAPITAL  ACCOUNTING 

sale  price  was  the  same  as  the  value  as  at  March  1,  1913, 
no  profit  accrues  for  tax  purposes. 

Had  this  item  been  a  depreciable  asset,  having  an 
established  value  at  March  1,  1913,  greater  than  the  cost, 
the  value  at  March  1,  1913,  would  be  the  depreciation  basis 
in  arriving  at  net  income,  but  it  would  not  be  the  depre- 
ciation basis  in  computing  invested  capital.  See  Article  844. 

17.  It  appears  that  the  corporation  paid  but  $5,000 
for  the  formula  and  carried  it  on  its  books  at  $6,000.    While 
it  may  have  been  worth  $6,000,  or  much  more,  we  can  allow 
only  the  cost  price. 

In  this  connection  it  is  interesting  to  note  that  if  we 
allowed  the  $6,000  value  to  stand  as  the  value  of  the 
formula,  and  the  $75,000  value  on  the  land,  that  the  profits 
tax  of  the  corporation  would  be  slightly  less  than  it  other- 
wise would  be,  due  to  the  fact  that  a  greater  average  asset 
value  would  result,  which  would  have  the  effect  of  reducing 
the  percentage  of  deduction  for"  inadmissibles  carried.  Had 
no  inadmissibles  been  carried,  the  values  at  which  the 
assets  are  carried  at  the  end  of  the  period  would  have  no 
effect  on  invested  capital  for  the  taxable  year,  for,  in  such 
case,  we  are  interested  only  in  the  values  at  the  beginning 
of  the  period. 

18.  The  redaction    of  the    reserves  for    patent  and 
switching  facilities,  brought    about  by  a    charge  to  the 
reserves  when  the  assets  are  being  developed,  has  no  effect 
on  invested  capital.    The  only  effect  is  to  reduce  the  value 
of  some  asset  and  a  corresponding  increase  in  the  value 
of  the  assets  under  development.     The  amount  that  the 
reserves  are  reduced  by  the  development  process  is  reflected 
by  an  equal  increase  in  surplus.    The  operation  is  precisely 
analogous  to  taking  money  out  of  one  of  your  pockets  and 
placing  it  in  another  of  your  pockets. 

19.  Since  it  was  stated  that  the  agent  could  find  only 


INVESTED  CAPITAL  ACCOUNTING  263 

certain  errors  or  thought-to-be-errors  in  the  books  of  the 
corporation,  it  must  be  presumed  that  this  item  was  rightly 
charged  to  Profit  and  Loss  during  the  period. 

20.  Do  not  allow  the  account,  Surplus,  to  deceive  you. 
Always  bear  in  mind  that  true  reserves,  undivided  profits, 
and  surplus  represent  the  same  thing  under  different  names ; 
that  the  combined  amount  of  these  items  is  the  "excess 
of  assets  over  the  total  of  liabilities  and  capital."  To  illus- 
trate by  abridged  balance  sheets — liabilities  side : 


Dec.  31, 1917  Dec.  31, 1918 

Capital  Stock $20,000  $30,000 

True  Reserves 4,000  13,000 

Surplus 16,000  12,000 

Undivided    Profits 5,000  10,000 


$45,000  $65,000 


Actual  surplus  at  the  beginning  of  the  year,  $25,000; 
at  the  end  of  the  year,  $35,000.  Assuming  that  no  dividends 
or  tax  was  paid,  or  other,  similar,  distribution  was  made 
during  the  year,  the  profit  for  the  year  is  the  difference 
between  these  two  figures — $10,000,  and  not  the  differ- 
ence between  the  amounts  of  undivided  profits. 

21.  The  Debenture  Bonds  are  borrowed  capital.  The 
fact  that  interest  has  not  been  paid  has  no  bearing,  and 
is,  doubtless,  in  harmony  with  the  wishes  of  all  bondholders. 
If  any  of  them  demanded  the  interest,  and  the  corporation 
refused  to  pay  it,  the  bondholders  making  the  demand  could 
enter  suit  and  recover  the  amount  due,  just  the  same  as 
any  other  creditor  could  do  if  he  wished  to  collect  an  amount 
due  him.  The  fact  that  the  bonds  were  issued  under  the 
stipulation  that  interest  was  to  be  paid  at  certain  times, 
made  it  mandatory  upon  the  corporation  so  to  pay.  Or, 


264  INVESTED  CAPITAL  ACCOUNTING 

to  put  it  another  way,  the  fact  that  it  was  not  stipulated 
that  the  interest  be  payable  only  upon  a  favorable  vote  of 
the  board  of  directors,  and  that  it  was  not  stated  that  the 
interest  should  not  be  cumulative,  places  the  holders  of 
the  bonds  on  a  par  with  other  creditors. 

Failure  of  the  corporation  to  live  up  to  its  obligations 
does  not  change  the  status  of  the  bonds  in  the  least.  That 
the  bondholders  were  the  stockholders  is  only  incidental. 
At  any  day  some  of  the  bonds!  might  go  into  the  hands  of 
persons  who  are  not  stockholders. 

Net  Income 

We  may  arrive  at  net  income  either  by  taking  the 
profit  for  the  period  as  shown  by  the  original  balance  sheets 
and  making  the  necessary  adjustments  by  adding  to  or 
taking  from  that  amount,  or,  we  may  determine  it  by  tak- 
ing the  difference  between  the  Surplus  accounts  as  shown 
on  the  amended  balatice  sheets  and  make  additions  thereto 
or  deductions  therefrom,  as  may  be  required  to  arrive  at 
the  true  taxable  income.  Both  methods  are  illustrated  in 
this  solution. 

The  First  Method 

Profit  as  shown  by  the  books $51,000 

Add:    Donations    $8,000 

Income  tax  paid 70,000 

Interest  disallowed 250 

Additions   to   Reserves 51,000 

Excess   Depreciation 4,250 

Salary  adjustment 1,000       134,500 


Total  net  income $185,500 

Less :    Dividend    received $3,000 

Interest  on  Liberty  Bonds 200 

Profit  on  Treasury  Stock 2,000 

Profit  on  sale  of  Land 20,000 

Appreciation  of  Land 20,000 

Appreciation  of  Formula 1,000        46,200 

Net  taxable  income $139,300 


INVESTED  CAPITAL  ACCOUNTING 


265 


The  Second  Method 


Surplus  Account  December  31,  1918 $139,100 

Surplus  Allocations  December  31,  1918 256,500     $395,600 

Surplus  Account  December  31,  1917 $104,850 

Surplus  Allocations  December  31,  1917 205,500       310,350 

Book  profit  for  1918 $85,250 

Additions : 

Income  tax  paid $70,000 

Donations    8,000 

Disallowed  interest   (paid) 250 

Salary  prepaid 1,000         79,250 

$164,500 
Deductions : 

Interest  received  on  Liberty  Bonds. . .  $200 

Dividend    received 3,000 

Profit  on  Treasury  Stock 2,000 

Profit  on  sale  of  Land 20,000        25,200 

Net  taxable  income $139,300 

Reconciliation — Amended  Balance  Sheets 

Taxable   income $139,300 

Other  income — Profit  on  Land $20,000 

Profit  on  Treasury  Stock 2,000 

Dividend    received 3,000 

Int.  on  Liberty  Bonds 200        25,200 

Total  income $164,500 

Less. — Int.  on  Inadmissibles   (paid) $250 

Donations 8,000 

Income   tax 70,000 

Additions  to  Reserves 51,000 

Salary  Adjustment 1,000       130,250 

Net  addition  to  Surplus $34,250 

Surplus  December  31,  1918,  Amended $139,100 

Surplus  December  31,  1917,  Amended 104,850 

Net  addition  to  Surplus $34,250 


266 


INVESTED  CAPITAL  ACCOUNTING 


Analysis  of  Capital  Stock,  Surplus  and  Reserves 

Surplus  as  on  books  at  December  31,  1917. .  $185,000 

Net  taxable  income  for  the  period 139,300 

Capital  Stock  as  shown  on  the  books 300,000 

$624,300 

Less:  Disallowed  Goodwill $59,000 

Treasury    Stock 27,000 

Employees*  Subscriptions 18,000 

Income  tax  paid 70,000 

Additions  to  Reserves 51,000 

Difference  between  book  value  and  par 
value  of  Treasury  Stock  at  begin- 
ning    3,000 

Interest  paid  on  Inadmissibles 250 

Donations    8,000 

Depreciation  to  December  31,  1917 . . .  24,150       260,400 

$363,900 

Add:  Stock  paid  for  during  the  year $15,000 

Profit  on  sale  of  Land 20,000 

Profit  on  sale  of  Treasury  Stock 2,000 

Difference  between  book  value  and 
par  value  of  Treasury  Stock  at  end 

of  year 2,000 

Interest  on  Liberty  Bonds 200 

Dividend    received 3,000        42,200 

Total  Cap.  St.  Surp.  and  Res.  December  31,  1918. $406,100 

Less  Capital  Stock  outstanding  December  31,  1918 267,000 

Surplus  and  Undivided  Profits  December  31,  1918 $139,100 

Surplus    and    Undivided    Profits    as    on    Amended    Balance 

Sheet,  December  31,  1918 $139,1QO 


Note — Had  Treasury  Stock  been  deducted  at  par,  but  one  adjust- 
ment of  stock  value  would  be  required  above — the  $2,000  ad- 
justment. 

Not  an  Unusual  Balance  Sheet 

Lest  you  form  the  opinion  that  the  original  balance 
sheets  presented  in  this  problem  are  "far  fetched"  you  are 


INVESTED  CAPITAL  ACCOUNTING  267 

assured  that  many  with  which  auditors  have  to  deal  are 
more  "scrambled"  than  this.  The  term  "typical"  properly 
captions  this  problem,  in  that  each  adjustment  necessary 
is  similar  to  adjustments  required  in  every-day  work  of 
auditing  returns.  It  is  not  intended  to  lead  you  to  think 
that  the  average  run  of  cases  necessitates  so  many  ad- 
justments. 

Goodwill  for  1919 

On  the  basis  of  stock  outstanding  at  December  31, 
1918,  we  should  allow  Goodwill  in  the  amount  of  $66,750 
for  1919. 


CHAPTER  FIFTEEN 
A  GOOD  PROBLEM 

Note — The  proposition,  that  follows,  together  with  its 
annotated  solution,  was  used  by  the  writer  in  his  1919 
excess  profits  classes.  It  was  the  first  involved  problem 
based  on  1918  tax  law  used  for  instruction  purposes  in  the 
Unit.  The  class  thought  so  well  of  it  that  a  request  was 
made  of  the  Training  Section  that  it  be  mimeographed  for 
distribution,  which  request  was  denied.  The  class  was 
determined  to  have  it  and  raised  a  fund  of  about  twenty 
dollars  to  have  fifty  copies  mimeographed  by  persons  in 
that  business.  Since  then  hundreds  of  copies  have  been 
made  on  the  typewriter,  and,  of  course,  by  this  method  of 
duplication,  errors  are  sure  to  creep  in. 

Later,  after  certain  changes  had  been  made  in  the 
administration  of  the  Training  Section,  many  mimeographed 
copies  were  distributed.  It  is  probable  that  this  problem 
has  been  studied  by  more  persons  than  all  the  other  invested 
capital  problems  combined. 

PROPOSITION  No.  1 

BALANCE  SHEET 
as  at  December  81,  1917 
Assets  Liabilities 

Cash    $10,000   Accounts  Payable $20,000 

Treasury  Stock 20,000   Bills  Payable 22,000 

Bills    Receivable 15,000   Reserve  for  Unpaid  Wages     1,000 

Accounts    Receivable 18,000   Reserve  for  Bad  Debts ...     4,500 

Inventory    110,000   Reserve  for  Depreciation.  40,000 

Municipal  Bonds 15,000   Reserve  for  Dividends 100,000 

Liberty  Bonds 20,000   Reserve  for  Contingencies     1,000 

Pullman  Co.  Bonds 17,000    Reserve  for  Federal  Taxes  50,000 

Swift  and  Co.  Stock 30,000    Reserve   for   Accrued   In- 

Plant   150,000       terest  1,500 

Land  and  Buildings 75,000    Capital  Stock 200,000 

Goodwill    80,000    Surplus   80,000 

Undivided  Profits 40,000 


$560,000  $560,000 


INVESTED  CAPITAL  ACCOUNTING  269 

The  net  earnings  of  the  corporation  were  $315,000. 
Dividends  were  paid  as  follows:  February  20th,  $10,000; 
May  3rd,  $25,000;  July  3rd,  $110,000.  Goodwill,  $80,000, 
was  paid  in  for  cash  and  actually  worth  $90,000. 

Corporation  received  (July  10)  dividends  on  Swift  and 
Company  Stock,  amounting  to  $2,500,  and!  on  September  1, 
the  stock  was  sold  at  an  advance  of  $7,500  over  cost.  The 
municipal  bonds  were  sold  at  cost  August  1st,  and  one-half 
the  proceeds  were  invested  in  National  Bank  Stock.  Octo- 
ber 1  the  Treasury  Stock  was  sold  for  $24,000  and  a  com- 
mission of  1%  was  paid  the  Broker  who  handled  the  trans- 
action. 

(1)  What  is  the  invested  capital  for  the  calendar 
year  1918? 

(2)  If  Goodwill  had  been  worth  but  $60,000  and  had 
been  paid  for  in  stock  of  the  corporation,  would  that  affect 
your  answer  as  to  amount  of  invested  capital  ? 

Note — It  is  assumed  that  no  changes,  other  than  those 
mentioned,  occurred  during  the  year  that  would  affect  in- 
vested capital. 


ANNOTATED  SOLUTION 

Swift  and  Co.  Stock— 

Statement:  Holdings  at  the  beginning  of  the  year 
$30,000;  dividends  received  July  10,  $2,500.  September  1 
the  entire  block  was/  sold  at  a  profit  of  $7,500. 

Since  income  from  stocks  held  in  other  corporations 
is  not  subject  to  excess  profits  tax,  the  amount  so  invested 
is  not  to  be  considered  as  an  admissible  asset. 

But  where  a  profit  results  from  the  sale  of  such  in- 
admissibles  a  portion  of  the  asset  is  restored  to  admissibles ; 


270  INVESTED  CAPITAL  ACCOUNTING 

in  the  above  case,  this  portion  is  the  percentage  that  the 
profit  bears  to  the  total  receipts  from  this  source.  Thus, 
we  have — 


Dividends    $2,500 

Profit   7,500 

Total  receipts $10,000 


The  formula  for  arriving  at  the  correct  proportion 
(Art.  817)  is— 


Profits  over  total  income  by  the  amount  of  stock  held — 


7,500 

x$30,000= $22,500  to  be  prorated  over  the  period — 

10,000 

January  1  to  September  1,  243  days 
243 

22,500x = average  amount  of  inadmissibles  restored 

365 
to  admissibles $14,979.45 


The  proceeds  of  the  sale  become  admissible 
from  the  date  of  sale  until  the  end  of  the  year, 
unless  such  proceeds  have  been  reinvested  in  other 
inadmissibles,  hence  we  have — 


Proceeds  of  sale  equals  cost  $30,000 
plus  profit     7,500 


$37,500  amount  that  be- 
comes admissible  from  September  1  to  December  31  prorated 
122 

$37,500x =    $12,534.25 

365 
Total  conversion  from  inadmissibles  to  admissibles $27,513.70 


INVESTED  CAPITAL  ACCOUNTING  271 

There  remains  a  certain  amount  of  this  stock  still  inad- 
missible, determined  as  follows: 


Total  holdings  of  Swift  and  Company  stock $30,000 

Amount  converted  by  reason  of  sale 22,500 

Inadmissible  portion $7,500 


This  amount  remains  inadmissible  from  January  1  to 
September  1,  243  days,  and  is  prorated  the  same  as  the  other 
portions  of  this  asset : 

243 

$7,500x =$4,993.15 

365 

Entry  on  adjusted  balance  sheet: 

Swift  and  Co.  stock  (admissible) $27,513.70 

(inadmissible) 4,993.15 

Proof :  Admissibles  plus  inadmissibles $32,506.85 

Less  the  $7,500  profit  prorated  on  the  basis  of  122/365 
of  a  year 2,506.85 


Difference  equals  the  original  holdings $30,000.00 


Had  this  stock  been  sold  at  a  profit  and  had  there  been 
no  dividends  received  or  receivable,  then  the  entire  $30,000 
would  have  become  admissible  up  to  the  date  of  the  sale, 
and  the  entire  proceeds  would  have  become  admissible  after 
the  date  of  the  sale,  provided,  that  the  proceeds  were  not 
reinvested  in  other  inadmissibles.  (See  Art.  817,  last  line 
but  one.) 

Or,  had  the  sale  been  made  without  profit  and  the 


272  INVESTED  CAPITAL  ACCOUNTING 

proceeds  of  the  sale  had  not  been  reinvested  in  other  inad- 
missibles,  then  the  entire  $30,000  would  have  remained 
inadmissible  up  to  the  date  of  the  sale  and  the  proceeds 
would  have  become  admissible  from  the  date  of  the  sale 
until  the  end  of  the  period. 

• 

Municipal  Bonds 

Statement:  Total  holdings  $15,000  all  of  which  were 
sold  August  1,  at  cost.  One-half  of  the  proceeds  of  the  sale 
were  at  once  reinvested  in  other  inadmissibles. 

This  is  an  inadmissible  item  for  the  reason  that  the 
Federal  Government  may  not  tax  income  from  obligations 
of  the  States  nor  the  obligations  of  subdivisions  of  the 
States,  and  no  asset  (always  excepting  Liberty  Bonds)  the 
income  from  which  may  not  be  included  in  net  income  is 
to  be  consid'ered  as  an  admissible  asset.  The  excess  profits 
tax  is,  in  large  measure,  dependent  for  its  basis  of  computa- 
tion on  the  amount  of  assets.  It  follows,  therefore,  that 
an  asset  that  does  not  contribute  to  excess  profits  should 
not  be  a  determining  factor  in  the  amount  of  those  excess 
profits. 

153 

$7,500x = average  or  prorated  amount  which  gives  us — 

365 

Admissible $3,143.84 


The  other  half  (not  sold)  gives  us  (averaged) 


Inadmissible    $3,143.84 

From  January  1  to  August  1,  or  212  days,  the  entire  $15,000 
remained  inadmissible,  prorated — 

212 

$15,000x =    8,712.32 

365 
Total  average  inadmissibles  for  the  year $11,856.16 

Proof:    Admissible  portion  added  to  inadmissible  portion  equals  the 
total  holdings,  or  $15,000. 


INVESTED  CAPITAL  ACCOUNTING  273 

Treasury  Stock 

Statement:  Stock,  par  value,  $20,000  sold  October  1,  for  $24,000. 
Commission  of  1%  to  brokers. 

Gross  receipts $24,000 

Less  1% 240 

Net  proceeds $23,760 

This  amount  becomes  an  admissible  asset  for  92  days.    (Art.  861.) 

92 

$23,760x = prorated  addition  to  admissible  assets.    $5,988.82. 

365 


Not  only  is  this  amount  added  to  admissible  assets,  but 
the  same  amount  must  be  added  to  invested  capital.  Had 
the  same  amount  of  outstanding  stock  been  bought  in,  the 
$5,988.82  would  have  to  be  deducted  from  admissible  assets. 
Also,  it  would  have  to  be  deducted  from  invested  capital 
unless  it  was  purchased  out  of  current  earnings.  See  Art. 
862,  4th  line  from  bottom.  But  no  earnings  would  ba  avail- 
able until  provision  had  been  made  for  accrued  income  tax 
and  to  take  care  of  any  dividends  that  may  have  been 
declared. 

Treasury  Stock,  like  disallowed  goodwill,  is  to  be  re- 
garded neither  as  an  admissible  nor  as  an  inadmissible 
asset.  Both  are  eliminated  from  the  adjusted  balance  sheet. 
Treasury  Stock  purchased  by  corporation  reduces  invested 
capital  by  the  amount  paid,  regardless  of  the  amount  for 
which  it  was  originally  sold. 

The  first  line  in  the  preceding  paragraph  concerning 
the  status  of  Treasury  Stock  was  a  bold  one  to  make  at 
that  time  (1919),  being  made  after  failure  to  get  any  one 
of  five  presumed-to-be  eminent  authorities  to  commit  them- 
selves on  the  subject  (only  five  were  consulted)  and  in  the 
face  of  positive  statements  to  the  contrary  appearing  in 


274  INVESTED  CAPITAL  ACCOUNTING 

a  book  on  income  tax  procedure  by  a  very  deservedly  emi- 
nent author.  This  statement,  as  well  as  many  others  made 
has  stood  the  test  of  time. 

Dividends 

Statement:  Net  earnings  were  $315,000.  Dividends 
declared  as  follows:  February  20,  $10,000;  May  3,  $25,000; 
July  3,  $110,000. 

Before  any  dividends  may  be  declared  out  of  current 
earnings  provision  must  be  made  for  the  income  and  profits 
taxes  that  have  accrued  during  the  taxable  year.  See  Art. 
857,  (2),  (a). 

It  is  impossible,  arithmetically,  to  determine  the  cor- 
rect amount  of  taxes  until  we  have  determined  the  amount 
of  invested  capital.  Also,  it  is  impossible  to  determine, 
arithmetically,  the  invested  capital,  in  case  of  its  impair- 
ment by  dividends,  until  the  amount  of  tax  is  known. 

Until  such  time  as  we  are  furnished  an  algebraic  for- 
mula for  solving  this  portion  of  the  problem,  we  can  only 
approximate  the  accrual  of  taxes  in  this  manner:  Compute 
the  invested  capital  under  the  hypothesis  that  current  earn- 
ings are  sufficient  to  cover  the  tax  and  the  dividends.  Then 
use  that  amount  in  determining  the  sufficiency  or  insuffi- 
ciency o£  the  earnings  to  take  care  of  both  taxes  (accrued) 
and  the  dividends.  If  the  earnings  are  sufficient,  the  amount 
of  invested  capital  you  based  your  computation  on  is  cor- 
rect. If  the  earnings  are  not  sufficient,  adjust  the  pre- 
sumptive invested  capital  accordingly  and  recompute  the 
tax  on  the  basis  of  the  adjusted  amount  of  invested  capital 
to  arrive  at  the  amount  of  tax  for  the  taxable  year.  See 
Art.  857.  (2),  7th  line  from  bottom. 

Observe,  however,  that  this  method  has  no  bearing  on 
the  adjustment  to  invested  capital  by  reason  of  income  tax 
paid  during  the  taxable  year  for  the  previous  year. 


INVESTED  CAPITAL  ACCOUNTING  275 

With  the  problem  before  us,  having  no  prewar  or  other 
data  necessary  to  the  correct  determination  of  the  tax,  we 
will  assume  that  the  amount  of  tax  paid  during  the  tax- 
able year  for  the  previous  year  is  just  the  amount  set  up 
in  the  balance  sheet,  $50,000.  Also,  we  shall  assume  that 
the  tax  for  the  taxable  year  is  $90,000. 

Now,  since  no  funds  are  available  for  dividends  until 
provision  is  made  for  accrued  taxes,  it  is  evident  that  the 
amount  available  is  the  net  taxable  income,  less  the  accrual 
of  income  tax,  hence  we  get  the  formula : 


Net  taxable  income $315,000 

Less  the  tax 90,000 


Available  for  dividends $225,000   divided 

by  365=:  $616.44  average  daily  earnings  available. 

Had  there  been  a  deficit  at  the  beginning  of  taxable 
year,  such  deficit  would  have  to  be  made  good  from  the 
net  $225,000  before  arriving  at  the  daily  average  earnings 
available  for  dividends.  Assume,  for  the  moment,  that 
a  deficit  did  exist  amounting  to  $112,500.  In  such  event 
the  available  daily  earnings  would  be  reduced  to  $308.22. 
See  Art.  838. 

Since  the  $10,000  dividend  was  payable  during  the  first 
sixty  days  of  the  period,  the  entire  amount  of  the  dividend, 
prorated  as  of  the  date  payable  must  be  deducted  from 
invested  capital. 

315 
$10,000x = $8,630.11 

365 

The  earnings  up  to  May  3  were  greater  than 
the  $25,000  dividend,  hence  no  adjustment  is  re- 
quired. 


276  INVESTED  CAPITAL  ACCOUNTING 

Brought  forward $8,630.11 

At  the  time  of  the  payment  of  the  $110,000 
dividend,  July  3,  the  available  earnings  amounted 
to  $616.44x183  days,  or  a  total  earnings  amount- 
ing to  $112,808.52.  Since  a  dividend  amounting  to 
$25,000  had  previously  been  paid,  it  must  be  de- 
ducted from  this  amount  of  earnings,  hence — 

Earnings  to  July  3 $112,808.52 

Less  dividend  paid  May  3 25,000.00 


Available  for  July  dividend $87,808.52 

Amount  of  July  dividend 110,000.00 


Decrease  of  invested  capital  July  3 $22,191.48 

July  3  to  December  31,  182  days,  prorated — 
182 

$22,191.48x = average  decrease $11,065.34 

365 
Total  reduction  of  invested  capital  caused  by  dividends  19,695.45 


Income  and  excess  profits  taxes  paid  for  the  previous  year,  at  June  15: 

200 
$50,000x = amount  deducted  from  invested  capital $27,397.26 

365 


We  now  come  to  the  matter  of  the  adjusted  balance 
sheet.  We  wish  to  determine  the  percentage  of  deduction 
from  invested  capital  by  reason  of  the  inadmissibles  held. 
(See  Art.  852.)  For  this  purpose  we  shall  cling  to  the 
assets  side  only.  We  shall  have  to  see  the  balance  sheet, 
assets  side,  not  only  at  the  beginning  of  the  year,  but  at 
the  end  of  the  year  and  in  this  respect  the  assets  side 
receives  different  treatment  from  that  given  the  liabilities 
side,  for  with  the  latter  we  are  concerned  only  with  what 
we  find  at  the  beginning  of  the  year.  No  consideration  is 
given  to  the  liabilities  side  of  the  sheet  at  the  end  of  the 


INVESTED  CAPITAL  ACCOUNTING 


277 


year.    Were  we  to  do  so,  it  might  in  effect  be  capitalization 
of  current  earnings,  where  it  is  not  permissible. 

What  we  want  is  the  average  inadmissibles  held 
throughout  the  year,  and  the  average  admissibles  plus  the 
inadmissibles  held  throughout  the  year.  (Art.  854.)  We 
take  for  the  invested  capital  items  the  amounts  appearing 
at  the  beginning  of  the  year  only,  and  adjust  them  by 
adding  or  subtracting  according  as  additional  capital  (not 
earnings)  has  gone  into  the  business  or  has  been  taken 
from  the  business. 

We  will  assume  that  the  net  earnings,  less  dividends 
paid,  were  reflected  in  additions  to  plant  at  the  end  of  the 
year.  It  is  immaterial  where  we  place  them  or  how  we 
distribute  them  over  the  asset  items — the  result  will  be 
the  same.  Cash  has  been  increased  by  the  net  amount 
received  from  the  sale  of  Treasury  Stock — prorated,  as 
well  as  by  the  profit  made  on  the  sale  of  Swift  and  Com- 
pany's stock. 


ASSETS— COMPARATIVE 


Jan.l 

Cash    $10,000.00 

Treasury  stock 20,000.00 

Bills  receivable 15,000.00 

Accounts  receivable 18,000.00 

Inventory  110,000.00 

Municipal  bonds — Admissible 

Inadmissible  . .  15,000.00 

National  Bank  stock 

Pullman  Company  bonds 17,000.00 

Swift  and  Co.  stock — Admissible 

Inadmissible    30,000.00 

Liberty  bonds 20,000.00 

Plant 150,000.00 

Land  and  Buildings 75,000.00 

Goodwill   80,000.00 


Dec.  31 
$36,260.00 


Average 
$17,187.45 


15,000.00 

18,000.00 

110,000.00 


7,500.00 
17,000.00 


20,000.00 

262,500.00 

75,000.00 

80,000.00 


15,000.00 

18,000.00 

110,000.00 

3,143.84 

8,712.33 

3,143.84 

17,000.00 

27,513.70 

4,993.15 

20,000.00 

20fl,250.00 

75,000  00 

80,000.00 


$560,000.00     $641,260.00     $605,944.31 


278  INVESTED  CAPITAL  ACCOUNTING 

Goodwill,  having  been  paid  for  in  cash,  is  allowable 
to  the  full  amount.  The  answer  to  Question  Two  is :  Good- 
will would  be  allowable  to  the  extent  of  25%  of  the  out- 
standing capital  stock  which  was  $180,000 ;  that  is  $200,000 
less  the  $20,000  Treasury  Stock,  or  a  total  Goodwill  allow- 
ance of  $45,000. 

The  profit  on  the  sale  of  Treasury  stock,  not  being 
subject  to  the  tax  (see  Art.  542)  and  not  being  included 
in  the  $315,000  net  income,  is  reflected  in  the  asset  cash, 
as  is  also  the  $2,500  dividends  received  on  the  Swift  stock, 
inasmuch  as  these  items  of  income  went  into  the  active 
assets  as  at  the  date  received. 

Note  that  the  additions  to  assets  through  the  sale  of 
inadmissibles  are  prorated  as  at  the  date  they  became  a 
part  of  the  admissible  assets,  while  the  net  profits  for  the 
year  are  averaged  as  having  been  a  constant  accrual. 

Analysis  of  cash  as  at  December  31 : 


On  hand $10,000 

From  sale  of  Treasury  Stock 23,760 

Dividend  received 2,500 

Total..  ..$36,260 


Analysis  of  cash  averaged: 

On  hand $10,000.00 

Prorated  amount  of  dividend  received  (2,500) 1,193.63 

Prorated  amount  of  Treasury  stock  sold  (23,760) 5,988.82 


Total  $17,187.45 


INVESTED  CAPITAL  ACCOUNTING  279 

Analysis  of  averaged  plant  account: 

At  beginning $150,000.00 

Profits $315,000.00 

Less  dividends  paid $145,000.00 

Less  stock  profit 7,500.00 

Less  taxes  paid 50,000.00       202,500.00       112,500.00 


Plant  at  December  31 $262,500.00 

Plant  at  beginning  of  the  year $150,000.00 

Plant  at  end  of  year 262,500.00 


2)412,500.00 
Averaged  amount $206,250.00 


The  profit  on  the  sale  of  Swift  and  Company  stock 
is  taken  out  of  the  net  profits  above  for  the  reason  that 
this  item  already  has  been  included  in  the  assets  at  the 
end  of  the  year  through  the  averaging  of  the  amount  of 
this  inadmissible  item  restored  to  admissibles. 

The  next  thing  to  be  considered  is:  What  are  the  in- 
vested capital  items  ?  For,  the  answer  we  must  turn  to  the 
liabilities  side  of  the  balance  sheet  at  the  beginning  of  the 
year.  See  Art.  854,  6th  line.  We  find  on  our  balance 
sheet — 


Reserve  for  bad  debts $4,500.00 

Reserve  for  dividends 100,000.00 

Reserve  for  contingencies 1,000.00 

Reserve  for  Federal  taxes 50,000.00 

Capital  stock $200,000.00 

Less  Treasury  stock 20,000.00       180,000.00 


Surplus 80,000.00 

Undivided  profits 40,000.00 


Total $455,500.00 


280  INVESTED  CAPITAL  ACCOUNTING 

Deductions : 

Prorated  income  tax  paid $27,397.26 

Impairment  by  dividends 19,695.45        47,092.71 

""  $408,407.29 
Addition : 

Prorated  amount  of  treasury  stock  sold 5,988.82 


Potential  invested  capital $414,396.11 


Reserves  for  unpaid  wages  and  accrued  interest  are 
not  true  reserves,  and  should  not  be  set  up  as  such,  though 
\ve  sometimes  see  it  done  that  way.  They  .are  deferred 
liabilities  and  stand  on  a  par  with  accounts  payable. 

The  amount  stated  as  potential  invested  capital  would 
be  the  actual  amount  of  invested  capital  had  the  taxpayer 
carried  no  inadmissible  assets  during  the  year.  Since  the 
taxpayer  did  carry  inadmissibles  we  must  reduce  this  poten- 
tial amount  by  the  percentage  that  the  average  of  inad- 
missibles bears  to  the  total  of  admissibles  and  inadmissi- 
bles, and  it  was  to  obtain  the  basis  for  this  computation 
that  all  the  work  of  averaging  to  obtain  the  average  asset 
column  of  assets  was  done. 

But  before  we  proceed  with  this  computation  we  have 
one  thing  further  to  consider,  and  that  is:  Does  our  aver- 
aged-asset  column  reflect  the  true  value  of  the  assets? 
See  Art.  852,  9th  line  from  bottom.  To  find  out  we  must 
look  into  the  matter  of  depreciation.  It  is  a  matter  often 
and  easily  overlooked.  In  this  instance  we  find  on  the  lia- 
bilities side  the  entry: 

Reserve  for  depreciation $40,000 

We  shall  assume  that  this  is  the  correct  amount.  If 
it  were  not,  we  should  have  to  determine  what  is  the  cor- 
rect amount  and  add  to  or  take  from  the  total  assets  accord- 
ing as  the  amount  was  found  to  be  too  small  or  too  large. 


INVESTED  CAPITAL  ACCOUNTING  281 

This  matter  of  depreciation  is  especially  easily  overlooked 
when  set  up  in  a  balance  sheet  as  it  is  set  up  in  the  one 
we  are  considering.  Were  it  set  up  as  shown  below,  it 
were  more  readily  and  unconsciously  taken  into  consid- 
eration : 


Plant $150,000 

Less  Reserve 40,000     $110,000 


In  such  case  you  see  it  already  would  have  been  de- 
ducted, and  that  is  what  we  must  now  do — 


Assets  as  determined $605,944.31 

Less  depreciation 40,000.00 


Net  assets $565,944.31 


Of  this  amount,  $16,849.32  are  inadmissible,  and  to 
find  the  net  deduction  from  the  potential  invested  capital 
we  use  the  formula: 


$16,849.32 

x$414,396.11  =  $12,337.42,  the  amount  to  be  deducted 

565,944.31 

from    $414,396.11,    leaving    a    true    invested    capital    amounting    to 
$402,058.69. 


In  one  respect  our  depreciation  deduction  is,  perhaps, 
not  quite  correct.  We  have  deducted  the  $40,000  as  set  up 
on  the  books  at  the  beginning  of  the  year.  During  the 
year  depreciation  would  take  place  and  whatever  the  amount 


282  INVESTED  CAPITAL  ACCOUNTING 

should  be,  it  should  be  reflected  in  the  assets  at  the  end 
of  the  year.    It  would  be  worked  out  this  way : 


Depreciation  reserve  at  beginning  of  year $40,000 

Depreciation  reserve  at  end  of  year 44,000 


2)84,000 
To  be  deducted  from  the  averaged  Balance  Sheet .  $42,000 


On  the  assumption  that  the  net  profit  of  $315,000  is 
based  on  sufficient  depreciation  having  been  charged  off 
at  the  end  of  the  year,  in  other  words,  that  the  net  assets 
were  increased  by  this  amount,  net,  then  the  problem  as 
worked  is  correct.  Had  the  problem  been  made  up  of  two 
complete  balance  sheets  as  at  the  beginning  and  as  at  the 
end  of  the  year,  there  could  have  remained  no  question 
as  to  how  much  or  how  little  depreciation  to  deduct  from 
assets. 

Do  not  lose  sight  of  the  fact  that  while  the  matter 
of  depreciation  that  takes  place  during  the  year  might  be 
considered  not  only  in  determining  the  average  assets  held 
during  the  year,  but  also  in  arriving  at  the  true  net  income, 
such  depreciation  has  no  bearing  on  invested  capital  as  of 
the  beginning  of  the  year,  and  no  adjustments  are  to  be 
made  to  invested  capital  by  reason  of  depreciation  taking 
place  during  the  taxable  year. 

Had  no  reserve  for  depreciation  been  set  up,  not  only 
would  the  assets  have  to  be  reduced  by  the  amount  of  de- 
preciation, but  the  surplus  also  would  have  to  be  reduced. 

In  computing  the  amount  of  tax  for  the  taxable  year 
any  dividends  paid  during  the  first  sixty  days,  as  well  as 
any  other  evident  impairment  of  capital  or  surplus  should 
be  adjusted  before  making  the  computation.  In  other 


INVESTED  CAPITAL  ACCOUNTING  283 

words,  aim  to  arrive  as  nearly  as  may  be  possible  at  the 
correct  amount  of  invested  capital  before  determining  the 
amount  of  accrued  taxes. 

In  case  you  were  considering  a  balance  sheet  having 
no  entries  on  the  liabilities  side  but  invested  capital  items, 
but  with  inadmissibles  on  the  assets  side,  the  formula  for 
ascertaining  the  percentage  of  inadmissibles  to  total  of 
admissibles  and  inadmissibles  need  not  be  followed.  Simply 
deduct  the  inadmissibles  from  your  invested  capital.  The 
result  will  be  exactly  the  same  as  it  would  be  were  you  to 
follow  the  percentage  formula. 


CHAPTER  SIXTEEN 
QUIZZER  NUMBER  ONE 
Applying  to  Chapter  Seven 

In  computing  invested  capital  in  the  following  ignore 
any  adjustments  that  are  not  required  by  the  explana- 
tions. 

1.  The  Balance  Sheet  of  the  Green  Marble  Company 
as  at  January  1,  1918,  is  as  follows : 


Assets  Liabilities  and  Capital 

Cash    $10,000  Accounts  Payable $40,000 

Receivables 140,000  Capital  Stock 200,000 

Inventory    30,000  Surplus   80,000 

Plant   ? 120,000 

Treasury  Stock 20,000 


$320,000  $320,000 


The  corporation  was  organized  January  1,  1915,  taking 
over  the  plant  of  A.  J.  Green  &  Company,  valued  at  $100,000 
and  for  which  stock  was  issued  in  a  like  amount. 

Owing  to  changed  conditions  due  to  the  war,  it  was 
necessary  to  carry  more  long-time  open  accounts  than  the 
working  capital  justified  and  the  concern  found  itself 
cramped  for  ready  cash.  To  overcome  this  handicap,  A.  J. 
Green  returned  to  the  corporation,  October  10,  1917,  stock 
amounting  to  $40,000,  with  the  stipulation  that  none  of  it 
should  be  resold  for  less  than  par  value — $100.  Since  Mr. 
Green  was  the  owner  of  95  per  cent  of  the  capital  stock  of 
the  corporation,  he  regarded  it  merely  as  taking  money 


INVESTED  CAPITAL  ACCOUNTING  285 

out  of  one  pocket  and  putting  it  in  another — both  pockets 
being  his. 

Of  the  stock  returned,  $20,000  was  sold,  December  12, 
1917,  for  cash,  at  par,  and  the  remaining  $20,000  was  sold 
June  10,  1918,  at  105.  The  stock  not  accounted  for  in  these 
explanations  was  issued  for  cash,  at  par,  prior  to  1917. 

Required:    The  invested  capital  for  1918. 


2.  (a)  The  A.  C.  James  Company,  composed  of  A.  C. 
James,  John  James,  and  Henry  James,  was  organized  De- 
cember 30,  1917,  with  an  authorized  capital  stock  of  $300,- 
000,  par  value  $100. 

A.  C.  James  subscribed  for  1,250  shares,  John  James 
for  825  shares,  and  Henry  James  for  825  shares,  all  of 
which  was  paid  for  in  cash,  at  par  value.  In  addition,  they 
turned  over  to  the  corporation  a  plant  fairly  worth  $20,000. 

On  the  basis  of  the  above  information,  set  up  a  balance 
sheet  (based  on  income  tax  procedure)  as  at  January  1, 
1918,  and  compute  invested  capital  for  1918. 


(b)  At  December  31,  1918,  John  James  decided  to 
retire  from  the  business.  He  transferred,  as  gifts,  200 
shares  to  A.  C.  James,  and  200  shares  to  Henry  James. 
He  sold  to  Frank  Allen  200  shares  for  $26,000  cash.  The 
remainder  of  his  holdings  he  turned  in  to  the  corporation 
as  Treasury  Stock,  without  compensation  at  the  time, 
merely  stipulating  that  the  corporation  should  pay  him 
par  value  for  it  at  such  time  as  in  the  opinion  of  the  Board 
of  Directors,  the  corporation  was  financially  strong  enough 
to  do  so.  This  stock  was  entered  on  the  books  as  an  asset 
at  par  value.  A  reserve  (charged  to  surplus)  was  set  up 
to  cover  this  item. 


286  INVESTED  CAPITAL  ACCOUNTING 

During  the  year  net  profits  amounted  to  $20,000,  all 
of  which  were  invested  in  additional  plant  facilities. 

On  the  basis  of  the  above  information,  construct  bal- 
ance sheet  (based  on  income  tax  procedure)  as  at  January 
1,  1919,  and  compute  invested  capital  for  1919. 


(c)  March  7,  1920,  A.  C.  James  became  "hard  up" 
by  reason  of  unfortunate  deals  in  the  stock  market  and 
sold  to  Frank  Allen  400  shares  of  his  stock  at  $90  a  share 
and  to  Henry  James  he  sold  200  shares  at  $80  a  share. 


On  April  10,  1920,  the  corporation  disposed  of  the 
Treasury  Stock  at  $110  a  share,  taking  in  payment  there- 
for a  lot  of  iron  castings  that  could  be  profitably  used  in 
the  business.  Later  an  inventory  of  the  castings  was  made, 
disclosing  the  fact  that  they  were  actually  worth,  at  fair 
market  price,  $27,750,  and  it  was  found  that  one-third  of 
them  would  not  be  of  use  during  the  year  1920.  In  fact, 
it  was  necessary  to  put  them  in  storage  to  be  used  at  some 
indeterminate  future  date. 

During  the  taxable  year  1920  the  concern  made  a  net 
profit  of  $36,000,  all  of  which  was  paid  out  in  dividends, 
December,  1920. 

Using  the  above  information  as  a  basis,  set  up  a  bal- 
ance sheet  (based  on  income  tax  procedure)  as  at  January 
1,  1920,  and  compute  invested  capital  for  1920. 


QUIZZEE  NUMBER  TWO 
Applying  to  Chapter  Eight 

1.  Inasmuch  as  a  Reserve  for  Bad  Debts  is  not  a 
deductible  item,  it  must  be  included  in  invested  capital. 
Note  the  different  ways  of  setting  up  a  balance  sheet : 


Assets  Liabilities  and  Capital 

(a)   Miscellaneous      A  s  -  Capital  Stock $75,000 

sets $100,000    Notes   Payable 25,000 

Accounts    Receivable.  .12,000    Surplus    20,000 

Notes  Receivable  . . .       8,000 

$120,000  $120,000 


(b)   Miscellaneous     As- 
sets     $100,000 

Receivable    . .  $20,000 
Less  Doubt- 

f  u  1    Ac-  Capital    Stock $75,000 

counts  ..     5,000     15,000  Notes  Payable 25,000 


$115,000  $115,000 


(c)   Miscellaneous      As-  Capital  Stock $75,000 

sets $100,000  Notes  Payable 25,000 

Accounts    Receivable     12,000  Reserve  for  Bad  Debts ...     5,000 

Notes  Receivable  . . .       8,000  Surplus    15,000 


$120,000  $120,000 


288  INVESTED  CAPITAL  ACCOUNTING 

Under  (a)  the  invested  capital  is  Capital  Stock  plus 
Surplus,  or  $95,000.  Under  (b)  invested  capital  is  Capital 
Stock  plus  Surplus  plus  the  reduction  for  doubtful  accounts, 
or  a  total  of  $95,000.  Under  (c)  invested  capital  is  Capital 
Stock  plus  Surplus  plus  Reserve  for  Bad  Debts,  a  total  of 
$95,000. 

2.  Reserve  for  Depreciation  is  not  invested  capital  since 
it  is  (if  the  true  amount  is  set  up)  a  deductible  item. 
Whether  or  not  a  Reserve  is  set  up,  depreciation  must  be 
deducted  in  arriving  at  net  income,  hence  it  can  not  be 
included  in  invested  capital.  Note — 


Miscellaneous  Assets. . .  .$100,000    Capital  Stock $100,000 

Machinery   $30,000  Accounts    Payable 10,000 

Less  deprecia-  Reserve    for    Federal 

tion   10,000        20,000       Taxes    10,000 

Surplus    38,000 

Buildings   40,000 

Less  deprecia- 
tion        2,000         38,000 


$158,000  $158,000 


We  find  that  machinery  has  been  in  use  four  years  and 
that  Its  life  period  should  be  20  years.  We  find  that  the 
buildings  should  have  a  life  period  of  40  years  and  that 
they  have  been  erected  ten  years. 

The  amount  of  depreciation  carried  as  a  reserve  (or 
otherwise  as  a  credit  to  an  asset)  has  no  bearing  except 
in  the  event  that  the  true  amount  is  set  up.  In  the  above 
the  true  amounts  are  not  set  up. 

In  the  above  proposition,  invested  capital  is  Capital 
Stock  plus  Reserve  for  Federal  Taxes  plus  Surplus,  or  a 
total  of  $148,000,  to  be  adjusted  by  adding  excess  deprecia- 
tion or  deducting  insufficient  depreciation. 


INVESTED  CAPITAL  ACCOUNTING  289 

Brought  down $148,000 

Machinery  four  years  by  5%  by  $30,000  gives  $6,000  as  the 

true  depreciation.    Excess  depreciation  (added) 4,000 


$152,000 

Buildings  ten  years  by  2%%  by  $40,000  gives  $10,000  as  the 
true  depreciation.  Insufficient  depreciation  (to  be  de- 
ducted)    8,000 


Invested    capital $144,000 


Suppose  the  balance  sheet  were  thus — 

Miscellaneous      As-  Capital    Stock $100,000 

sets    $100,000  Accounts  Payable 10,000 

Machinery    30,000   Reserve  for  Federal 

Buildings    40,000       Taxes    10,000 

Reserve  for  Depreciation  12,000 

Surplus   38,000 


$170,000  $170,000 


Invested  capital  is  Capital  Stock  plus  Reserve  for  Fed- 
eral Taxes  plus  Surplus,  or  a  total  of  $148,000  apparently. 
BUT,  since  the  reserve  is  not  sufficient  to  cover  the  depre- 
ciation, we  must  reduce  this  amount  by  the  insufficiency 
of  the  Reserve,  which  is  $4,000  as  shown  in  the  first1  depre- 
ciation computations,  leaving  an  invested  capital  of  $144,000. 

Note  that  the  Reserve  for  Federal  Taxes  is  included 
in  invested  capital.  Inasmuch  as  this  is  due  and  payable 
June  15,  it  is  evident  that  it  will  be  out  of  the  business  for 
200  days,  hence — 

$10,000x200/365  is  $5,479.45  which  amount  must  be 
deducted  from  $144,000  leaving  a  net  invested  capital  of 
$138,520.55. 


290  INVESTED  CAPITAL  ACCOUNTING 

Miscellaneous  Reserves  Problem — 

Various   Assets $120,000    Capital  Stock $100,000 

Accounts  Receivable 16,000   Notes  Payable 18,000 

Notes    Receivable 4,000   Reserve  for  Depreciation 

Real  Estate  (appraisal) .   200,000        (O.   K.) 10,000 

Treasury   Stock    (bought                  Reserve  for  Taxes 25,000 

at  par) 30,000   Reserve  for  Federal 

Sugar   Inventory 30,000       Taxes    36,500 

Reserve  for  Sugar  Loss.  5,000 
Reserve  for  New  Build- 
ing      50,000 

Surplus    75",000 

Undivided  Profits. .      ...  80,000 


$400,000  $400,000 


Treasury  ,Stock  sold  May  26  for  $36,000.  Land  cost 
$125,000  in  1911.  Value  as  at  March  1,  1913,  $165,000. 
There  are  no  improvements  on  the  land. 

At  December  31,  1918,  fearing  a  big  decline  in  the 
price  of  sugar  a  Reserve  was  set  up  to  guard  against  paying 
out  too  much  in  dividends.  The  $25,000  tax  Reserve  is 
to  cover  state  and  county  taxes  for  the  year  just  ended 
and  which  are  payable  January  15  of  the  taxable  year. 


Invested  capital,  Capital  Stock  less  Treasury  Stock $70,000 

Plus   Reserves   for   Federal   Taxes,   Loss   in 

Sugar,  New  Building 91,500 

Plus  Surplus  and  Undivided  Profits 155,500 


$317,000 
Less    Federal   taxes   for    200    days— $36,500 

X200/365    20,000 


$297,000 

The  invested  capital  would  be  $297,000  except  for  the 
fact  that  the  real  estate  is  carried  at  an  appraised  value, 


INVESTED  CAPITAL  ACCOUNTING  291 

$75,000  more  than  it  cost.  Deducting  this  from  $297,000 
leaves  $222,000.  To  this  we  must  add  the  receipts  (pro- 
rated) from  the  sale  of  Treasury  Stock:  $36,000x220/365 
=.$21,698.63  plus  $222,000  gives  a  net  invested  capital  of 
$243,698.63. 

If  the  real  estate  (land)  had  been  carried  at  less  than 
cost  we  should  add  back  the  difference  between  the  value 
at  which  it  is  carried  and  the  cost  price. 


Treasury  Stock  Problem 

Miscellaneous  Assets $50,000   Capital   Stock $150,000 

Plant  (acquired  by  Notes  Payable 25,000 

stock)    150,000   Surplus    25,000 

Treasury  Stock 30,000 


$230,000  $230,000 


First  Assumption — 

Plant  acquired  for  stock  of  the  corporation  at  par. 
Treasury  Stock  returned  to  the  corporation  at  a  nom- 
inal sum. 


Invested  capital  is — 

Capital  Stock  less  Treasury  Stock $120,000 

Plus  Surplus,  BUT,  inasmuch  as  the  Treasury 
Stock  was  reacquired  at  a  nominal  sum,  it  is 
assumed  that  the  plant  was  worth  only  the  par 
value  of  the  stock  retained  by  the  donor,  hence 
Surplus  must  be  reduced  by  this  inflated  value; 
that  is,  $55,000  minus  $30,000 25,000 

Invested  capital $145,000 


292  INVESTED  CAPITAL  ACCOUNTING 

Second  Assumption — 

Plant  acquired  for  cash  or  for  stock  at  par  and  it  is 
conceded  that  the  plant  was  worth  this  amount.  Treasury 
Stock  purchased  at  par. 


Invested  capital  is — 

Capital  Stock  less  Treasury  Stock ..$120,000 

Plus   Surplus 5'5,000 


Invested  capital $175,000 


It  seems  well  again  to  point  out  the  fact  that  Treasury 
Stock  is  not  an  asset  and  that  the  foregoing  balance  sheet 
does  not  conform  to  correct  technique.  If  it  were  presented 
as  below  (the  only  correct  way  of  showing  Treasury  Stock) 
the  real  invested  capital  would  be  more  readily  apparent. 


Assets  Liabilities  and  Capital 

Miscellaneous  Assets $50,000   Notes  Payable $25,000 

Plant   (acquired    by  stock  Capital   Stock.  .  .$150,000 

issue)    150,000       Less  Treasury 

Stock    30,000  120,000 

Earned    Surplus.  55,000 


$200,000  $200,000 


Stock  outstanding   ($120,000),  plus  Surplus   ($55,000) 
equal  invested  capital  ($175,000). 


INVESTED  CAPITAL  ACCOUNTING  293 

Now  Test  Your  Knowledge 

BALANCE  SHEET 
THE  MOLINE  LINSEED  OIL  COMPANY 

as  at  December  31,  1918 

Assets  Liabilities  and  Capital 

Cash    $20,000   Accounts  Payable $35,000 

Notes  Receivable 19,000  Reserve  for  Amortization 

Accounts  Receivable 11,000       of  Goodwill 11,000 

Inventory    95,000    Customers'   Reserve 20,000 

Plant   300,000  Allowance    for    Deprecia- 

Goodwill    55,000       tion  (O.  K.) 31,000 

Treasury     Stock    (bought  Capital  Stock 300,000 

at  par) 10,000    Surplus    113,000 


$510,000  $510,000 


In  taking  inventory  the  corporation  realized  that  nearly 
everything  in  its  line  was  taking  an  upward  trend,  hence, 
it  valued  everything  at  market  if  that  was  higher  than 
cost,  or  at  cost,  if  the  market  of  that  particular  item  had 
declined,  for  it  was  believed  that  the  trifling  declines  were 
but  temporary,  and  such  they  later  proved  to  be.  The 
total  variation  amounted  to  $7,000. 

During  1918,  to  induce  certain  good  customers  to  pur- 
chase oil  in  large  quantities  the  company  agreed  that  if  the 
price,  during  1919,  should  average  five  per  centum  (or  more) 
less  than  the  price  the  customer  paid  for  the  oil,  it  would  re- 
turn to  the  customer  the  difference  between  the  price  he  paid 
for  the  oil  and  the  average  price  at  which  the  oil  could 
have  been  purchased  during  1919.  Late  1919  it  appeared 
that  not  only  would  the  corporation  have  to  refund  the 
amount  of  the  reserve,  but  perhaps  a  greater  amount. 


294  INVESTED  CAPITAL  ACCOUNTING 

At  December  31,  1918,  it  was  decided  to  set  up  a 
Reserve  for  Amortization  of  Goodwill  over  a  period  of 
five  years.  The  matter  of  Goodwill  not  yet  being  presented 
to  you  in  text  form,  it  is  but  fair  to  state  that  the  amount 
carried,  $55,000,  would  be  permissibly  reflected  in  invested 
capital.  The  Reserve  for  this  purpose  was  a  charge  to 
Surplus.  All  stock  was  issued  at  par  value  for  cash  or  its 
equivalent. 

Required:    Invested  capital  for  1919. 


QUIZZER  NUMBER  THREE 
Applying  to  Chapter  Nine 

BALANCE  SHEET 

SAXON  CHEMICAL  COMPANY 
December  SI,  1917 

(1)                   Assets  Liabilities  and  Capital 

Cash    $25,000    Capital  Stock $300,000 

Plant   160,000   Accounts  Payable 90,000 

Real  Estate 100,000  Reserve  for  Bad  Debts. .     15,000 

Patent   15,000  Reserve  for  Federal 

Formulae    (a) 20,000        Taxes    50,000 

Formula    (b) 10,000  Reserve  for  Depreciation    40,000 

Treasury  Stock 70,000  Reserve    for    Contingen- 

Goodwill    100,000       cies 65,000 

Miscellaneous  Assets 200,000   Undivided  Profits 35,000 

Surplus   105,000 


$700,000  $700,000 


Note — The  technician  would  object  to  this  arrangement 
of  the  balance  sheet,  but  it  suits  our  purpose  best 
this  way. 

History  of  the  Case 

The  corporation  was  organized  January  1,  1914,  at 
which  time  Capital  Stock  was  issued  for  property  as 
follows : 

Plant    $160,000 

Patent    15,000 

Formulae    (a) 20,000 

Goodwill  65,000 

Cash    40,000 


Total $300,000 


296  INVESTED  CAPITAL  ACCOUNTING 

The  Treasury  Stock  was  acquired  by  the  corporation 
in  December,  1917,  for  cash  and  other  property,  at  par. 

The  patent  is  very  valuable  and  the  corporation  re- 
quests permission  to  revalue  it  and  to  have  the  actual 
value  ($57,000)  reflected  in  Surplus.  It  has  never  charged 
off  any  depreciation  on  the  patent. 

Formula  (b)  was  purchased  for  cash. 

It  has  been  definitely  ascertained  that  the  Goodwill 
was  actually  worth  much  more  than  it  cost,  based  on  par 
value  of  the  stock  issued  therefor,  probably  as  much  as 
$250,000,  but  the  company  wishes  to  be  conservative  and 
carries  it  at  $100,000. 

During  the  taxable  year  $19,000  was  charged  off  for 
Bad  Debts.  Income  tax  for  1917  amounting  to  $18,250  was 
paid  March  15,  1918. 

The  amount  of  Reserve  for  Depreciation  seems  to  be 
correct  up  to  the  date  of  this  balance  sheet,  but  during 
the  taxable  year,  it  appears  that  $3,000  too  much  was 
charged  off. 

(Owing  to  lack  of  space,  the  balance  sheet  as  at  De- 
cember 31,  1918,,  is  not  presented,  but  it  is  found  that  at 
June  12,  1918,  the  concern  obtained  permission  to  increase 
Capital  Stock  to  $400,000,  which  was  that  day  issued  for 
property  as  follows: 

Tangible  property $60,000 

Intangible  property 20,000 

Notes   20,000 

The  notes  were  given  by  one  of  the  original  stock- 
holders, the  company  discounted  them  at  the  bank,  having 
$19,000  placed  to  its  credit  as  a  result.) 

February  3,  1918,  a  dividend  in  the  amount  of  $16,000 


INVESTED  CAPITAL  ACCOUNTING  297 

was  declared.     The  earnings  up  to  this  date  amounted  to 
$12,500. 

A  close  scrutiny  of  the  expense  account  reveals  that 
in  May,  1918,  the  company  installed  a  new  series  of  chemi- 
cal tanks,  at  a  total  cost  of  $12,300.  Of  this  amount,  $1,050 
was  for  the  services  of  an  engineer  for  mapping  locations, 
etc,,  and  $2,140  was  for  services  and  materials  necessary 
to  prepare  the  tank  locations.  All  of  this  $12,300  was 
charged  to  expense.  It  also  developed  that  during  1917 
a  number  of  oxygen  containers  were  installed,  at  a  total 
cost  of  $18,750.  Of  this  amount,  $14,000  was  for  the  con- 
tainers, $2,750  was  for  new  piping  and  connections  inci- 
dent to  the  installation  of  the  containers.  The  balance  was 
for  labor.  All  of  these  items  were  charged  to  expense. 

On  August  4,  1918,  $50,000  of  the  Treasury  Stock  was 
sold  for  $48,000  cash. 

On  August  11,  1918,  one  of  formulae   (a)   was  sold 
for  $10,000  cash.    Originally  this  group  consisted  of  three 
formulae,  all  being  considered  of  equal  value. 
Required :  The  invested  capital  for  1918. 

(2)  In  1913  the  Horton  Company  earned  above  all  divi- 
dends and  other  disbursements,  $9,000.  In  1914  it  lost 
$3,000  by  reason  of  having  to  pay  higher  prices  for  mate- 
rials to  fulfill  contracts  entered  into  in  1913.  In  1915  it 
earned  a  large  sum,  all  of  which  was  credited  to  Surplus. 
In  1916  it  lost  all  it  earned  in  1915  and  $6,000  additional. 
In  1917  it  earned  $38,000  and  declared  a  dividend  of  $20,000. 
During  these  periods  its  Capital  Stock  was  $200,000.  Ignore 
any  statutory  adjustment  not  called  for  by  these  explana- 
tions. What  is  the  invested  capital  for  1918  ? 


QUIZZER  NUMBER  FOUR 
Applying  to  Chapter  Ten 

BALANCE  SHEET 
THE  STANDARD  MACHINE  COMPANY 

December  31,  1917 

(1)  Assets  Liabilities  and  Capital 

Cash    $82,000  Accounts  Payable $27,000 

Receivables 33,000  Bonds  (20  year) 100,000 

Plant   150,000  Reserve  for  Federal  Taxes  18,250 

Bond  Fund 25,000  Funded   Reserve 25,000 

Edison  Company  Bonds..  20,000  Capital    Stock 150,000 

Copper  Stocks 15,000  Surplus   54,750 

Western  Union  Telegraph 

Stock    10,000 

Goodwill    40,000 


$375,000  $375,000 


History 

Organized  January,  1913,  taking  over  the  business  of 
W.  B.  Moses  &  Company.  The  stockholders  of  the  cor- 
poration had  been  the  partners  in  the  concern  taken  over. 
The  plant  had  a  life  of  25  years  after  acquisition  and  was 
worth  $212,000,  but  it  was  acquired  for  stock  amounting 
to  $150,000  and  carried  on  the  books  at  that  figure.  The 
Goodwill  attaching  to  the  corporation  was  worth  $40,000. 
No  Paid-in-Surplus  was  set  up  on  excess  value  of  plant. 
Income  tax  paid  in  1918  for  1917  was  $18,250. 

May  1,  1918,  the  Edison  bonds  were  sold  for  $22,000 
and  interest  amounting  to  $600  was  received  on  them  at 
about  the  same  date. 


INVESTED  CAPITAL  ACCOUNTING  299 

September  10,  the  W.  U.  Stock  was  sold  at  a  profit 
of  $500.  No  other  income  was  received  from  this  source. 

The  copper  stocks  were  sold  October  3  for  $20,000, 
which  amount  included  an  available,  but  unpaid  dividend 
of  10  per  cent.  Receipts  from  inadmissibles  were  not  rein- 
vested in  inadmissibles. 

A  dividend  of  $30,000  was  declared  and  payable  March 
12,  1918.  Earnings  up  to  this  date  amounted  to  $40,000, 
plus  the  accrued  income  and  profits  taxes. 

No  depreciation  has  been  charged  off,  the  corporation 
contending  that  the  usual  repairs  are  sufficient  to  continue 
the  plant  at  100  per  cent  value. 

Assuming  that  the  total  assets  at  December  31,  1918, 
amounted  to  $410,000,  and  that  this  amount  is  the  result 
of  adjustments  based  on  invested  capital  procedure,  what 
is  the  invested  capital  for  1918  ? 


In  1908  the  Cutler  Company  acquired  a  patent  in  ex- 
change for  stock,  par  value,  $100,  amounting  to  $30,000. 
During  1910-11-12  the  patent  was  greatly  improved,  and 
all  the  costs  of  development  were  consistently  charged  to 
Expense.  These  amounts  aggregated  $28,165. 

During  1914  and  1915  further  improvements  were  made 
at  a  total  cost  of  $17,520  all  of  which,  were  entered  on  the 
books  as  charges  to  Surplus.  At  March  1,  1913,  the  patent 
was  revalued  at  $74,000,  but  the  revaluation  was  not  set  up 
on  the  books. 

The  capital  stock  outstanding  March  3,  1917,  was 
$50,000.  During  1917  additional  stock,  amounting  to  $150,- 
000  was  issued  at  par,  for  cash.  The  Balance  Sheets  (con- 
densed) for  1918  are  as  follows: 


300  INVESTED  CAPITAL  ACCOUNTING 

Assets:  December 31, 1917  December 31, 1918 

Cash    $10,000  $35,000 

Plant    135,000  140,000 

Patent    30,000  30,000 

Standard  Oil  Stock 25,000 

Miscellaneous   Tangibles 80,000  110,000 

Goodwill   45,685  45,685 


$300,685  $385,685 


The  Oil  Stocks  were  purchased  December  2,  1918.  The 
Goodwill  was  set  up  in  1917  and  represents  the  amounts 
expended  for  development  of  patents.  Just  how  the  book 
entries  were  made  is  not  essential  to  this  problem. 

Income  Tax  paid  in  1918  for  1917  was  $35,000. 


Liabilities : 

Capital    Stock $200,000  $200,000 

Income  Tax  Reserve 35,000  35,000 

Surplus   Allocations 20,000  30,000 

Surplus    45,685  120,685 


$300,685  $385,685 


Required:  Invested  Capital  for  1918. 


QUIZZER  NUMBER  FIVE 
Applying  to  Chapter  Eleven 

1.  Part-year  Proposition — 

The  Union  Hardware  Company  has  been  filing  its  return 
on  the  fiscal  year  basis,  as  at  April  30.  It  is  decided  to 
file  future  returns  on  the  calendar  year  basis,  and  a  return 
is  filed  for  the  eight-month  period  ended  December  31, 
1918. 

The  net  income  for  the  taxable  period  is  $100,000; 
invested  capital,  $125,000.  The  net  income  for  the  pre- 
war period  averaged  $30,000;  average  pre-war  invested 
capital,  $70,000. 

Assume  that  income  tax  for  the  fiscal  year  May  1, 
1917,  to  April  30,  1918,  was  $24,500.  No  dividends  were 
paid  that  would  affect  invested  capital. 

Compute  the  income  and  profits  taxes  for  the  period. 


2.  A  Mining  Proposition — 

During  1918  the  Colorado  Minerals  Company  was  en- 
gaged in  mining  silver,  lead,  and  gold,  from  which  all  of 
its  income  was  derived. 

In  keeping  records  of  the  expenses  applicable  to  any 
particular  branch  of  the  business  items  were  not  always 
charged  to  the  proper  account,  but  went  into  a  "Miscel- 
laneous Expense"  account. 

The  gross  receipts  were  $3,100,000.  Here,  also  the 
bookkeeping  was  faulty,  inasmuch  as  all  receipts  were 


302  INVESTED  CAPITAL  ACCOUNTING 

credited  to  one  general  account  without  differentiation,  but, 
since  the  value  of  all  concentrates  was  credited  to  the  Com- 
pany upon  the  books  of  the  milling  company  immediately 
after  passing  through  process,  it  was  possible  to  ascertain 
from  the  books  at  the  mills,  the  proportionate  amounts, 
making  up  the  grand  total.  Those  books  reflected:  Silver, 
$875,000;  Lead,  $965,000. 

The  mining  company's  books  showed  the ,  following 
expense  totals : 


Gold    $800,000 

Silver  610,000 

Lead  450,000 

Miscellaneous  expenses 620,000 


Total  expenses $2,480,000 

Consider  all  expense  items  allowable.  Disregard  the 
fact  that  inventories  of  unsmelted  ore  might  change  the 
result. 

(a)  What  is  the  total  taxable  income  ?    How  would  the 
tax  be  computed  ? 

(b)  Assume  that  the  invested  capital  for  1918  was 
$1,400,000;  that  the  average  pre-war  invested  capital  was 
$1,000,000;  that    the    average    pre-war    net    income  was 
$125,000.    What  is  the  total  tax  liability  for  1918? 


3.   Part  Government  Contract  Proposition — 

An  examination  of  the  books  of  the  Colby  Company, 
Inc.,  manufacturers  of  furniture,  educed  the  following: 

Average  pre-war  invested  capital,  $200,000.     Average 
pre-war  earnings,  $20,000. 


INVESTED  CAPITAL  ACCOUNTING  303 

July  18,  1917,  the  Company  entered  into  a  contract 
with  the  Government  for  the  manufacture  of  cases  for 
wireless  apparatus.  Gross  income  from  this  source  $150,- 
000.  Expenses  attributable  to  this  portion  of  the  business, 
$110,000. 

August  3,  1917,  the  Company  entered  into  a  contract 
with  the  Standard  Aircraft  Corporation  for  the  manufac- 
ture of  wood  parts  for  airplanes.  The  Standard  Company 
had  a  Government  contract  to  manufacture  planes. 

The  Colby  Company  continued  to  manufacture  their 
regular  lines  of  furniture,  the  gross  receipts  from  which 
were  $250,000.  Expenses  and  losses  attributable  to  furni- 
ture manufacturing  were  $180,000. 

The  total  gross  income  of  the  Colby  Company  was 
$600,000.  The  total  expenses  were  $400,000,  of  which 
amount  $30,000  could  not  be  attributed  to  any  particular 
division  of  the  business.  It  is  assumed  that  the  $400,000 
includes  a  reasonable  amount  for  depreciation. 

Condensed  balance  sheets  follow: 


Assets :  December  81, 1918  December  81, 1919 

Cash    $30,000  $20,000 

Accounts    receivable 95,000  100,000 

Inventory   70,000  80,000 

Plant   105,000  110,000 

Sundry  assets 50,000  100,000 


$350,000  $410,000 


friabilities : 

Notes   payable $60,000  $60,000 

Capital   Stock 250,000  250,000 

Surplus    40,000  100,000 


$350,000  $410,000 


304  INVESTED  CAPITAL  ACCOUNTING 

No  inadmissibles  were  carried  at  any  time.  Receipts 
from  manufacturing  is  the  only  income.  No  goodwill 
set  up. 

October  10,  1919,  the  Company  paid  a  dividend  of 
$100,000.  The  Federal  taxes  for  1918  were  $40,000. 

Required:    The  income  and  profits  taxes  for  the  calendar 
year  1919. 


GENERAL  QUIZZEE  NUMBER  SIX 

Fiscal  Year  Proposition 

THE  HORTON  MERCANTILE  COMPANY 
BALANCE  SHEETS 


ASSETS                          June  30,1917 
Cash    «1  8-nnn 

June  30  ,19  18 
$23,000 
26,000 
96,000 
3,000 
25,000 
30,000 

June  8  0,19  19 
$46,000 
22,000 
102,000 
3,000 
25,000 
20,000 
10,000 
30,000 
55,000 
4,000 
8,000 
15,000 
20,000 

.   17,000 

Inventory    

.   80,000 

Furniture  and   Fixtures  

3,000 

Patent    

.  25,000 

General  Electric  Stock     .  . 

.  35  000 

Atlas  Cement  Company  Bonds 
Municipal  Bonds  

.   10,000 

10,000 
60,000 
4,000 
9,000 
10,000 
20,000 
30,000 
50,000 

Store  and  Office  Building  

.   65,000 

Deferred  Charges  

.     4,000 

Bond  Discount.  .  .        ... 

10,000 

Retirement  Fund  

.     5,000 

Real   Estate 

20  000 

Treasury  Stock  

.   30,000 

Goodwill   

.   50,000 

50,000 

$372,000 

$396,000 

$410,000 

LIABILITIES 

Outstanding  Bonds $50,000 

Notes  Payable 6,000 

Depreciation    Account 20,000 

Reserve  for  Government  Income 

Tax    30,000 

Reserve  for  Bad  Debts 1,500 

Reserve  for  Contingencies 5,000 

Reserve    for     Depreciation     of 

Patent    1,500 

Surplus  58,000 

Capital  Stock 200,000 


50,000 

7,000 

25,000 

30,000 
2,000 


3,000 

79,000 

200,000 


$372,000     $396,000 


50,000 

3,500 

30,000 

30,000 
2,000 
4,000 

4,500 

86,000 

200,000 

$410,000 


306  INVESTED  CAPITAL  ACCOUNTING 

Other  facts — 

(a)  Atlas  Cement  Company  bonds  were  acquired  Feb- 
ruary 1,  1919. 

(b)  Municipal  bonds,  amounting  to  $20,000  were  pur- 
chased August  1,  1918. 

(c)  Of  the  General  Electric  stock,  $5,000  was  sold  Jan- 
uary 2,  1918,  at  cost,  and  $10,000  was  sold  March 
1,  1919,  for  $11,000.    On  this  stock  no  dividends 
were  received  until  July  25,  1919,  at  which  time 
according  to  the  books,  an  8%  dividend  was  de- 
clared and  paid. 

(d)  All  transfers  or  sales  of  stock  were  at  once  re- 
corded on  the  books  of  the  General  Electric  Com- 
pany in  the  names  of  the  purchasers. 

(e)  The  Retirement  Fund  was  created  in  compliance 
with  the  terms  of  the  contract  entered  into  with 
the  purchases  of  the  outstanding  bonds.     These 
bonds  were  sold    May  31, .  1917,  at    a  discount 
of  10%. 

(f )  The  Treasury   stock   was   purchased   at   par,  for 
cash.    The  lot  was  sold  at  par  July  2,  1918. 

(g)  Disregard  the  item  of  depreciation,  except  that 
the  Depreciation  Account  is  to  be  regarded  as 
correct. 

(h)  June  30,  1916,  the  corporation  decided  to  amor- 
tize the  patent  by  making,  at  the  end  of  each  year, 
beginning  June  30,  1916,  a  charge  to  Surplus  of 
$1,500.  The  patent  was  acquired  for  stock. 

(i)  Goodwill  (in  addition  to  the  patent)  was  acquired 
for  stock  of  the  corporation  at  par  value,  but  is 
regarded  as  being  worth  much  more  than  the 
$50,000  stock  issued  therefor.  At  the  time  of  its 


INVESTED  CAPITAL  ACCOUNTING  307 

acquirement,  the  corporation  had  a  bona  fide  offer 
of  $55,000  for  this  same  block  of  stock,  and  the 
seller  of  the  goodwill  actually  was  offered,  in  cash, 
for  the  goodwill,  the  sum  of  $50,000. 

(j)  The  remainder  of  the  stock  was  issued  for  cash 
or  tangible  property  at  par  value. 

(k)  A  dividend  amounting  to  $40,000  was  paid  July  5, 
each  year.  Available  earnings  exceeded  the  divi- 
dends. 

Required:  The  invested  capital  for  the  fiscal  years  ended 
June  30,  1918,  and  June  30,  1919,  and  the  total  income 
taxes  for  the  year  ended  June  30,  1919.  Ignore  any 
income  tax  that  may  have  been  paid  or  payable. 


14  DAY  USE 

RETURN  TO  DESK  FROM  WHICH  BORROWED 
LOAN  DEPT. 

This  book  is  due  on  the  last  date  stamped  below,  or 

on  the  date  to  which  renewed. 
Renewed  books  are  subject  to  immediate  recall. 


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General  Library 
University  of  California 
Berkeley 

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M511214 


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